Monday, July 27, 2009

A China Bubble ?

Every so often a new media theme catches my attention, usually because I see it mentioned in various publications and/or blogs within a fairly short period of time. Lately I have been reading about what some people claim is a "bubble" in the Chinese economy and/or its stock market. A weekly chart of this index is visible just above this post.

A couple of weeks ago an academic paper by some "econophysicists" appeared which asserted that a bubble in the Shanghai composite index had developed. At the top of this post you can see an image of the chart which appeared in that academic paper. The paper's authors concluded:

"By the very nature of the model, this result gives us two conclusions. Firstly, there exists a bubble in the Shanghai Composite Index. Secondly, it will reach a critical level around July 17-27, 2009. This will lead to a change in regime which may be a crash or a more gently bubble deflation. "

Is there really a China Bubble?

I don't think so and here is my reason.

It is always possible to recognize an incipient bubble by looking at the price chart of the asset in question. I discuss this point on pages 112-114 of my book. What should you see on the chart? Well, you should see a prolonged period of advancing prices, generally measured in years, which has brought the price of the asset to new historical highs. Do we see this the chart of the Shanghai composite index?

Definitely not. Prices have been rising for less than a year from a low point in 2008. And that low culminated a drop of nearly 75% in the index - a drop that doubtlessly produced an enormous bear crowd in the Chinese stock market. It takes a long time for extensive bearish sentiment to dissipate and be replaced by correspondingly strong bullish sentiment. Eight months is not nearly enough time - eight years is more like it. Moreover, as you can see on the chart, the index is trading at only about half the level of its 2007 high point. There won't be any possibility of a bubble until the index is at new historical highs above 6100.

So I think the prediction of the econophysicists will be proven wrong because they have ignored the nature of the mechanism which produces bubbles and subsequent crashes.

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