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Everything You Need To Know About The Chinese Stock Market Bubble

This post first appeared on The Felder Report Premium on June 20, 2015.

I’ve mentioned the Chinese stock market mania here briefly in recent weeks. I’ve now compiled a fair amount of data along with some interesting anecdotes that show just how crazy it’s gotten so I thought I’d spend this week’s market comment laying it all out for you.

The first thing I like to focus on is valuations. If the dot-com bubble is the gold standard, then China is a bona fide financial bubble. According to Bloomberg:

Valuations in China are now higher than those in the U.S. at the height of the dot-com bubble just about any way you slice them. The average Chinese technology stock has a price-to-earnings ratio 41 percent above that of U.S. peers in 2000, while the median valuation is twice as expensive and the market capitalization-weighted average is 12 percent higher, according to data compiled by Bloomberg.

Another way to look at it is to compare current valuations around the world:

I’ve made the case that US stocks are more overvalued than they appear due to the fact that the median stock is now more highly valued than ever. There’s now a very similar but far more dramatic situation going on in China. Again, from Bloomberg:

The problem with the Shanghai Composite is that 94 percent of Chinese stocks trade at higher valuations than the index, a consequence of its heavy weighting toward low-priced banks. Use average or median multiples instead and a different picture emerges: Chinese shares are almost twice as expensive as they were when the Shanghai Composite peaked in October 2007 and more than three times pricier than any of the world’s top 10 markets.

So if US stocks are expensive on a median basis, Chinese stocks are incredibly so. What’s pushed valuations so far is euphoria like we may have never seen here at home. More than any developed stock market in the world, China’s is driven mainly by individual investors rather than institutions. This means that it’s probably more influenced by what Keynes termed “animal spirits” than most. And boy are there signs of those “animal spirits” in China today.

The number of new trading accounts being opened is simply stunning. I don’t know if I’ve ever seen a more dramaticly parabolic rise in anything.

And they’re not just buying stocks with cash. They’re using an incredible amount of debt, aka margin financing, to leverage their purchases right now.

What I find so stunning is that there are really no margin regulations on individual trading accounts. Yes, the brokerage firms all implement their own sort of margin limits mainly to cover their own asses but the regulators essentially allow for infinite leverage. In other words, it’s 1929 in China right now. The regulators are now considering implementing a 4-to-1 ceiling. To put this in perspective, the SEC allows for 2-to-1 leverage for US investors. Still it’s pretty plain to see what exactly is driving prices higher right now:

Though they make up the majority, it’s now gone far beyond individual investors. The Wall Street Journal reports that some manufacturing companies in China have completely shut down their main operations and put their cash to work in the stock market. Fully 97% of the growth in manufacturers profits now comes from this source of “income.” It’s hard to fathom just how insane this is: Manufacturers realizing they can make more money trading each others’ stocks than actually running their manufacturing businesses.

It’s also the growing popularity of index funds pushing prices to astronomical levels. A great example of this was the recent trading in Hanergy and Goldin Financial. Here were a pair of stocks that everyone knew were extremely overvalued. But they grew to a size that required index funds to add them to their portfolios. Now consider those valuation statistics above. 94% of Chinese stocks are valued more highly than the index. How many of these have also grown to a size that requires them to be purchased by index funds? I guess we probably won’t find out until the dust settles.

And if you think all these new traders and index funds, which are clearly at the mercy of some pretty hot money, are long-term investors, think again.

These guys make our dot-com era day traders look like Warren Buffett. The Chinese stock market just set a record for the shortest average holding period in history, just one week.

For some context here’s what happened to Taiwanese stocks after they witnessed the sort of frenetic turnover now driving the Chinese stock market. They fell about 80% over the course of just 8 months or so:

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“So how did we get here?” you may ask. I’ll let the FT explain:

There is one sense, though, in which euphoria in mainland Chinese equities is unusual. Far from being an unintended consequence of policy, the authorities are egging investors on with articles in the state-run press seeking to justify extreme valuations. The People’s Bank of China has been busy cutting interest rates.

And they have not yet cracked down on the incredible leverage being used by individual investors. The powers that be in China have carefully cultivated this incredible bubble. The reason they have done so is that, after the huge boom they have created over the past 20 years or so, they are now facing a potentially huge bust, especially in real estate (sound familiar?).

John Hempton recently wrote a blog post about his personal experiences with the incredible over-investment in China that is now coming home to roost. It sounds like Potemkin Villages on steroids over there.

And companies have been continuing to lever up even in the face of a deteriorating economy.

…until very recently.

So the equity bubble is a desperate attempt to avoid or at least ameliorate the damage of the economic bust the country now faces. The FT reports:

Why, you might ask, would those charming officials in Beijing wish to encourage a bubble? A consequence of the investment boom is that many state-owned enterprises are lossmaking, while state-owned banks have lent excessively to these companies and to local governments. The authorities are urging them to lend more despite the fact that they will never be repaid in full. The obvious way to de-risk this dangerous game of extend and pretend is to recapitalise the state-owned corporate sector. Bubble valuations will make this easier and cheaper.

Will it work? That is the $64,000 question. Still, I think it’s fairly easy to answer. Every other bubble in history has ended the same way. It’s popped. For the Chinese authorities to think they can avoid these consequences is probably fairly naive. Still, their grip on power over the country may depend on it so I don’t expect they stop short of doing whatever it takes to keep the game going. Having said that, once sentiment turns against the markets, it’s probably impossible for anyone to stop it.

Hanergy may actually provide a decent example for what that looks like. Once the game was up, it ended in a flash – literally less than a second.

Amazingly, the person who may have take greatest advantage of the situation was the company’s Chairman, Li Hejun, who shorted a boatload of his own company’s stock just prior to plunge.

Li is not alone. Reuters reports that Chinese corporate insiders are selling at a record pace.

In May company insiders – senior executives or their relatives – sold a combined 1.68 billion shares, a tripling from April, and much more than in each of the previous months of this year, according to data compiled by Reuters… A similar trend was captured by an index compiled by Shenwan Hongyuan Securities that tracks major shareholders’ trading activities. The index surged over the past month, to a record high, meaning major shareholders are reducing holdings at unprecedented levels.

It looks like all those individual investors, manufacturers-turned-day-traders, and index funds are going to left holding the bag. Last week the market lost 12.5%. A few weeks ago I suggested the ETF below had potentially seen blowoff-type volume. Now I’m even more convinced. And I wouldn’t be surprised to see a Taiwanese-style bust over the next 6 months or so. sc-6On a broader level, if this is the end of the Chinese equity bubble it has major ramifications for every other market and economy around the globe. For this reason, I expect more market participants to start paying very close attention.

We’ll just have to stay tuned and see how it all unfolds.

Disclosure: I own put options on ASHR.

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Investors Are Bullish On The Stock Market But Should They Be?

A week ago I put out a call to the bulls. I was looking for someone to demonstrate why stocks are likely to outperform the risk-free rate over a number of years (3,7 and 10 were the examples I gave). I’ve gotten a few responses since but they mostly feel like half-hearted attempts to explain why investors are still bullish rather than why they should be bullish.

Here’s a good example:

First off, I am in complete agreement with the observation (and your comments) that current valuations on US stocks are so high that rates of return over the next 7 to 10 years are likely to be very low to negative.
 
However, valuations have never been (as far as I can tell) a market timing mechanism.  The broad history of the US stock market is that prices advance until a recession is imminent.   Even after the declines in 1962 (Cuban Missile Crisis) and 1987 (Portfolio Insurance Debacle) the market went on to new highs before the next recession. 
 
My supposition for why this occurs is encapsulated in the chart below.  So long as the economy is expanding and as a result carrying consumer confidence higher, then investors (whether it is rational or not) will continue to pay higher valuations for equities. 

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Until there is a recession, investors are comfortable bidding stock prices higher.  

Here’s another one:

Okay, I’m not REALLY a bull, but this is the best I could figure for a bull case for equities…

Executive Summary: Hyperinflationary Monetary Supernova (Fed buys all US Government debt and forgives it all).

Narrative:

  1. After a 20% dip in equities, the Fed panics and launches into QE4. Equities begin an aggressive rally.
  2. After some time, the Fed notices that equities have again stalled and the yield on the ten year note isn’t falling quickly enough for their tastes (perhaps spooked by all the money printing). So they buy Treasuries even more aggressively. Equities rally some more.
  3. But the bond market isn’t falling for it, and to keep Treasury rates low, the Fed ends up having to buy all of the Treasury market that is available to buy. Equities are going ballistic by now.
  4. Having defined inflation out of existence, and seeing no economic growth (even as interest rates continue to rise), the Fed decides that even more radical steps are necessary to protect the economy. After much internal deliberation, the Fed announces that it is forgiving all of the Treasury debt that it owns, and furthermore, it will continue to purchase new issuance from the Treasury department. The hyperinflationary monetary supernova sends equities soaring.

And another:

For the record I’m not a “bull” and don’t seek to make a bullish case for equities. I was intrigued by the challenge and allowed myself a few minutes to ponder.

At the risk of sounding philosophical, I am going to give you a philosophically-sounding answer. Think of an 8-yr-old boy asking his mom if Santa Clause is real. (He has some newfound doubts because he’s heard some naysayers at school talking.) Is Santa celebrated every year? Yes. What’s Santa’s track record? A perfect 8 for 8: a gift under the tree every year of the boy’s life.

It doesn’t matter what the boy should know, the truth; what matters is what he’s told to believe. As long as the common knowledge holds he can reasonably extrapolate forward. However, the moment he ceases to believe and tells his parents as much, his odds of receiving another gift from Santa drop dramatically. There doesn’t have to be a sound reason to support the bull case at this juncture. It is what it is until it isn’t.

These are all fascinating things to think about but none of them demonstrate why stocks are likely to outperform the risk-free rate over any number of years in the future. Still, I’ll tackle each one briefly here.

First, it’s true that bear markets usually coincide with recessions so it may be true that we are unlikely to see stocks decline meaningfully while the economy remains fairly strong. Still, this argument only argues against a coming bear market rather than making a positive case for equities. How likely is the economy to avoid recession over the next 3, 7 or 10 years? I have no idea. But this forecast is critical to the case being made here.

Additionally, it seems like the past couple of recessions may have been triggered by major asset price declines as much as anything rather than the reverse. If this is true, then waiting for a recession to tell you when to get out of stocks is likely to be a losing proposition.

As for the hyper-inflationary case, this is sort of a spin on the familiar “this time is different” argument for owning stocks. While it may be an interesting exercise to think about these sort of possibilities, we really have no reason to believe that the Fed is likely to pursue policies that would create and sustain hyper-inflation. In fact, history shows the Fed would do everything in its power to avoid hyperinflation.

Finally, in regard to the Santa Claus analogy, this sort of reminds me of Pascal’s Wager. From Wikipedia:

Pascal’s Wager is an argument in apologetic philosophy devised by the seventeenth-century French philosopher, mathematician and physicist Blaise Pascal (1623–62). It posits that humans all bet with their lives either that God exists or not. Given the possibility that God actually does exist and assuming an infinite gain or loss associated with belief or unbelief in said God (as represented by an eternity in heaven or hell), a rational person should live as though God exists and seek to believe in God. If God does not actually exist, such a person will have only a finite loss (some pleasures, luxury, etc.).

Applying this idea to investors, bulls may posit that ‘given the possibility that an omnipotent Fed does exist and assuming an infinite gain or loss associated with belief or unbelief in said Fed, a rational person should live as though an omnipotent Fed exists. If it does not actually exist, such a person will have only a finite loss.’ This may be the ultimate “this time is different” argument. The Fed has never been, nor will it ever be omnipotent. Still, I think this begins to explain how some investors view the market these days.

But the analogy also brings up another point which is a critical insight into current market psychology: So long as we collectively believe the Fed is omnipotent then we will continue to receive the benefits of their magnanimous policies. As soon as we begin to doubt the Fed’s powers, the confidence game is up and we can no longer expect those gifts under the tree at the open of trading every day.

I think this is very close to what’s going on in the minds of many investors today. While I find the Santa Claus argument lacking in terms of making a convincing case for stocks outperforming the risk-free rate, I think it does a fantastic job of explaining why investors feel they should be bullish right now.

I received a few other responses but nothing that met my simple criteria. The lack of convincing arguments is either due to the fact that there just isn’t a compelling case to be made or I have just cultivated the sort of audience that doesn’t believe in Santa Claus. Either way, I still think it’s very difficult to justify owning risk assets once they have become priced so high as to virtually guarantee they underperform riskless ones. If you disagree and have a convincing case for me, I’m all ears.

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Calling All Bulls

It’s no secret I’ve been bearish but in the spirit of seeing the other side of the trade, I’ve been looking for a compelling bull case for equities for some time now. So this is a call to all the equity bulls out there. I’m looking for someone to make a compelling case for owning the broad US stock market over the next 3, 7 and/or 10 years.

I’m using these timeframes because I’ve shown here that margin debt suggests 3-year returns could be very poor. Jeremy Grantham’s shop, GMO, believes 7-year real returns will be negative. And there are plenty of measures that suggest 10-year returns should be close to zero. In fact, if the Fed is right, and demographics do matter to asset prices, returns over the coming decade could be significantly worse than zero.

Here are the ground rules. Any bullish case for equities under consideration here should:

  1. Be more than just a trend-following argument. I know the uptrend is in tact but that, in itself, doesn’t mean investors are likely to generate positive returns in coming years.
  2. Do more than simply criticize the CAPE (which is not even mentioned above) or any other measure, for that matter. Debunking any of my previous studies is welcomed but that’s not going far enough. It should make the positive case for owning equities going forward.
  3. Demonstrate, using some sort of historically valuable (meaning more than merely one prior occurrence) measures, that equities will likely outperform the risk free rate over any of the aforementioned time periods.

Send your responses here. I’m eager to see what you come up with. I’ll select a few that meet this criteria for publication here.

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Why It’s So Dangerous To Compare Equity Valuations To Interest Rates Right Now

A lot of people have tried to justify today’s extremely high stock market valuations by comparing price-to-earnings ratios to interest rates. Much has been written about why this can be such a problematic way to view equities (see this and this). But here’s one very simple reason why this is potentially a disastrous mistake today: Extremely low interest rates have inflated the earnings side of the price-to-earnings ratio making valuations, at least by this measure, appear far cheaper than they would otherwise. And comparing these inflated earnings-based valuation measures to ultra-low interest rates only compounds the problem.

Carl Icahn recently told Fox Business: “You can borrow money so cheaply and you look at earnings. These earnings are sort of false earnings. They’re based on very low interest rates.” I believe what he’s referring to is the explosion in profit margins which have historically been highly correlated to interest rates. From the chart below it’s plain to see how low interest rates make for higher profit margins and vice versa. Falling interest rates have been a fantastic tailwind for profit margins for decades now. Most recently, ultra-low interest rates have led to record-high profit margins:

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Think these high profit margins are sustainable? As Warren Buffett wrote back at the height of the dot-com bubble, “In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.” Today they are roughly twice that level. Paul Tudor Jones recently had this to say about the boom in profit margins: “Right now we might be in the grips of one of the most disastrous [manias] certainly in my career.”

Using price-to-earnings ratios to value the stock market today assumes this profit margin mania will go on forever. Yet, from the chart above it appears that the incredible boom in corporate profit margins may be coming to an end even without a major uptick in interest rates. Still, if rates continue their upward trajectory of the past couple of months it will likely mark the final nail in the coffin for the credit supercycle that has been the major driving force behind this boom (see this). This also means that valuations as measured by price-to-earnings ratios could soar as profit margins revert revealing just how expensive stocks, in fact, have now become.

For this reason, investors are currently being deceived by low interest rates, which suppress price-to-earnings ratios, into believing stocks are cheap especially relative to low interest rates! Once this illusion vanishes, however, they are likely to be very disappointed. This is the thinking behind this sort of statement Icahn made recently: “The interest rate bubble is I think holding [the stock market] up.” Julian Robertson recently attempted to quantify just how dangerous this low interest rate illusion is for the stock market by saying “I don’t think it’s at all ridiculous to think an ’08-size [decline is coming].”

Ultimately, comparing price-to-earnings ratios, which have been corrupted by ultra-low interest rates, to low interest rates themselves amounts to double counting, at the very least. At worst, it’s simply rationalizing an indicator that is not very helpful to begin with in terms of forecasting future returns, which, at the end of the day, is really what investors should care about (see this). So continue to rationalize your exposure to equities however you please. Just know that many of the greatest investors of all time are now taking the other side of that trade.

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3 Logical Fallacies Underpinning The Current Stock Market Mania

Monday I tweeted:

A few folks asked me what I was referring to so I thought I’d explain in a bit more detail here. First, John Hussman has recently made some very good points as to why a prudent investor may want to consider weighing the prospects for future equity returns against the potential risks. Very simply he suggests that in every prior market cycle stock market valuations fell to roughly half their current level (see the tweet below).

Now it’s become popular to rationalize this fact by attacking Hussman’s credibility. However, this totally ignores the issue at hand, that stocks are now as extremely overvalued as ever hence risk to the downside is about as great as it has ever been. Even if a source is not credible (and I personally believe Hussman’s research is very solid) that doesn’t invalidate the fact that that source is bringing to the table. This is nothing more than a classic logical fallacy.

Another interesting example of the rationalizing going on today is whenever someone points out that equity valuations are extremely high, critics immediately point to interest rates to “justify” those high valuations. However, this is nothing more than a red herring to distract from the main point: high valuations imply low future returns along with heightened risk. Do interest rates ameliorate these concerns? Not in any way. To paraphrase “Fight the Fed Model,” they merely tell us how we got here (low rates inspire greater risk taking).

In fact, a very common response I’ve heard to any suggestion that stocks are extremely overvalued is that bonds are even more overvalued than stocks. If it’s true that bonds are in a bubble AND they are what’s supposedly justifying record-high median equity valuations it’s hard not to believe that equities are in a bubble, as well. Ultimately, deferring to the interest rate discussion is nothing more than a classic distraction technique.

Finally, I’ve presented a few graphics over the past few months that visually display the risk/reward equation now facing investors. According to Jeremy Grantham’s GMO, investors in the stock market face a possible decline of about 40% (risk) in order to now achieve a 7-year annual return of about -2% (return).

The common response to this is, “you can’t time the market,” which is nothing but a straw man. Seeing the risk/reward equation for what it is and then appropriately positioning is not “timing the market.” It’s called “investing.”

So rationalize these indicators at your own risk. Just be aware of the logical fallacies at work because they are at the root of the single greatest mistake investors make. It might also be noteworthy to observe the prevalence of this sort of thinking to begin to have some sort of idea of where we stand in terms of the larger market cycle.

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