MorningWord 7/9/15: Chinese Stock Rally Was Born Into A Grave

by Dan July 9, 2015 9:41 am • Commentary

Back in early 1998, when I was still a kid, I completed my first winning trade, it was in enterprise software vendor PeopleSoft (ticker PSFT, a company that was bought by Oracle in 2005 for $10 billion).  I remember my excitement of coming in the morning after I bought the stock and it being up a couple bucks on a brokerage upgrade.  I quickly sold the stock, booked the gain, sat back in my seat with a cocky smirk on my face and likely said to myself, that was easy.  Little did I know the stock market that I was in during the onset of my career was born into a grave.

In hindsight the volatility that existed in the late 1990s was a dream for traders nimble enough to turn tail on longs and go the other way over short periods of time, but the inefficiency of the markets, poor electronic trading tools in the hands of few, loose rules regarding dissemination of information and the general optimism about a new-found technological utopia was all the kindling that a tech stock market bubble needed.  There were obviously other economic ingredients, but in my mind the bubble of that period could not have inflated without retail interest in getting into the game, coupled with the dramatic advantages of market professionals.

For those that traded during that period, and through the subsequent crash and prolonged bear market that followed will likely have those experiences imprinted on their current thought process. I certainly do, which makes it very hard not to draw comparisons between that period in the U.S, and what is going on in China now.  The last few years of the 1990s saw an explosion of retail participation in stock trading as a result of the proliferation of online trading platforms. We have all seen the explosion in Chinese retail participation with tens of millions openings of late. Get this, the number of trading accounts is 80% of the entire population of the United States, per Business Insider:


I have heard, read and debated many smarter than I suggesting that retail investors are not fueling the recent parabolic rise to the June highs in Chinese stocks and the subsequent 30% decline in the Shanghai Comp, but I just don’t buy it. This sort of silliness cannot occur without a greater fools theory in full effect.

Looking back at the chart of the Nasdaq Composite from the start of 1999, to the end of 2000 it is hard not to see the Shanghai Comp of now.  The Nasdaq doubled from summer 1999 to its highs in 2000, and then round-tripped the entire move by the end of 2000:

Naasdaq Comp 1999 through 2000 from Bloomberg
Naasdaq Comp 1999 through 2000 from Bloomberg

There are some that think the wealth effect isn’t real but all you have to do is go back to 2000 to remember that the collapse of the Nasdaq was at the heart of the early aughts recession. And the housing collapse was at the heart of the 2008 recession. The economy is affected by how good people feel about their financial future.

The Shanghai Comp broke out above 2500 in late 2014, and doubled, and has since declined 30%, but clearly in a downtrend:

Shanghai Comp since 2014 from Bloomberg
Shanghai Comp since 2014 from Bloomberg

Counter trend rallies will be violent, and there are sure to be many of them, but make no mistake, this Chinese equity bubble was born into a grave.  As I have been saying for a couple weeks, I suspect the Shanghai Comp will overshoot on the downside, just as it did on the upside, and before its all said and done will likely round-trip at least back to the 2500 breakout level from late November.  For those that are nimble and can employ disciplined risk management there will be no shortage of trading opportunities, I will likely focus on shorting rallies, and I certainly don’t expect the trading on either side to be easy. But I am jaded.