Wednesday, August 19, 2009

China Bubble Revisited

The Chinese stock market has had a big break of nearly 20% over the past two weeks. A daily bar chart of the last year's action of the Shanghai composite index is at the top of this post.

Below that chart you will see an image of the cover of the latest issue of The Economist. I've noticed that some commentators are offering this cover story as a contrarian justification for thinking that the rise in the Chinese stock averages over the past 9 months is a bubble - with the implication that a crash is underway.

I commented on this situation a couple of weeks ago in this post. There I observed that bubbles can develop when markets are at all time highs, but are very, very unlikely when the market is nearly 50% below its all time high as the Shanghai composite index was a few weeks ago at 3400. Of even more importance is the fact that after a 75% drop in prices a huge bear market crowd always forms - China is no exception to this rule. And it takes years, not months, for the bear crowd to disintegrate.

So I don't think we have seen a stock market bubble in China end at the 3400 level in early August. Instead I think the Shanghai composite is in a bull market that will probably take it above the 5000 level over the next couple of years. Notice that the 200 day moving average (red line highlighted by green arrow) is trending upward with the current price well above that line. This is a positive evidence for an ongoing bull market. I expect the drop from the August highs near 3400 to end not far from current levels.

How far down is the drop from the 3400 level likely to carry? I have drawn a trend line (blue dash line) connecting the reaction lows of the bull market thus far. It currently stands at about 2650. The midpoint of the up swing that started in early March 2009 is roughly at 2775 (horizontal red dash line). So I think this reaction will end somewhere in the purple oval.

Another remark on contrarian thinking. After a bubble or a crash in any market the subsequent move in the opposite direction always attracts the attention of amateur contrarians. They offer headlines or cover stories like this one from The Economist as reasons why recent history is about to repeat itself. But in this they are generals fighting the last war because, in retrospect, it looked so easy to win. They ignore the dynamics of market crowds-it takes a long time for public sentiment to swing from bearish to bullish or from bullish to bearish.

In the case of the Chinese stock market lots of current bears want a chance to be heroes - in retrospect they see how they could have easily handled the 2007-08 bear market in the Shanghai composite if only they had seen it coming. They want to fight the last war because it looks easy in retrospect. I fear their hopes will be disappointed.


  1. Interesting prespective. Its nice to read another point of view. Enjoy both your blogs.

  2. Great post! Me Chinese fully agree with you. Do you think Shanghai index is going to fill the gap of end of the May?
    By the way, your comment matchs the HongKong famous veteran's view, he consider China is like HongKong in 70's which has a very bright perspective for another 10 years.

  3. I've purchased your book from my favorite online bookstore I'm anxious to read it. I am grateful I found you several months back wished I would have discovered you sooner, but I feel very fortunate to be able to read your opinions. Thank you for sharing your expertise, opinions and insight, I hope you are right!

  4. Appreciate your posts and love your book.
    I was wondering, why a similar logic wouldn't apply to the dollar.

    The dollar has been in a bear market for 8 years now. It has then rallied for 8 months. There are still folks on TV, media calling for replacing the dollar.

  5. In 1930, the Dow retraced 50%. No bubble, says Carl.

  6. Very good observations. I think the best analogue is the 1937 crash to the year 2008 crash. A large rally is due / happening, but do we see a 1942 equivalent low? ie: year 2012 - 2013.

  7. ...lots of current bears want a chance to be heroes - in retrospect they see how they could have easily handled the 2007-08 bear market in the Shanghai composite if only they had seen it coming. They want to fight the last war because it looks easy in retrospect.

    Nicely put. I hear a lot of bears complaining about all the bulls, but I see few bulls. All over the blogs I see almost nothing but bears.

    Yet, historically, an uptern of the 200d SMA is very bullish in the short to medium term. And when bears start trotting out the experience of 1929-30: they have to go back 80 years to find a counter example? Yes, a replay of the awful Great Depression could happen, but it's not likely. Historical probability is not always correct (that's why it's probability, not certainty), but I would rather be on the side of probability than fighting against it. As Damon Runyon said, "The race is not always to the swift nor the battle to the strong, but that's the way to bet."

  8. Nasdaq went up 35% in the summer of 2000, after having fallen 35% from the top. Couldn't be a bubble.

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