China outdoes Wall Street

Chinese investors can't get enough Special Treatment shares...

EVERY DAY in every way, this market just keeps getting better and better.

   Copper up. China up. Everything up. How much higher can everyone get?

   You may have less than 437 days before the Olympics begin in Beijing next year....and counting. But at this rate, China's stock market is going to increase three or four times by then.

   And that's a conservative estimate.

   China's CSI 300 Index went above 4000 for the first time yesterday, while the lazy Americans and Europeans loafed on holiday – Memorial, Pentecostal and Whitsun.

   And here's another sign of Chinese growing status. Over $50 billion worth of shares traded in Shanghai and Shenzhen yesterday. That topped the $43.9 billion in shares traded in New York last Friday.

   There is clearly plenty of liquidity in the Chinese stock market. But there's also a surplus of stupidity. Or, if we're being kind, there's an abundance of inexperience with the cruel nature of capital markets.

   Cop this. Exactly 362,719 brokerage accounts were opened on China's stock market in a single day, May 24, according to the China Depository and Clearing Company. And for five straight days, over 300,000 new accounts were opened...every single day!

   This year alone, over 20.9 million new brokerage accounts have been opened. An entire Australia of speculators is hard at work in China, trying to "lift the sedan chair" as the local investors' lingo puts it.

   This is quickly shaping up to be the biggest wealth transfer and mass financial calamity of the last twenty years. You can't exactly blame neophyte Chinese savers. In an effort to boost domestic spending, the central government has capped the interest rate on short-term bank deposits at just over three percent. This barely keeps up with inflation.

   Why not pour your money into the market, then? After all, it's gone up 200% this year. You don't have to be a stock market wizard to realize that 200% is better than 3%.

   Here's a suggestion to James Packer, Australia's richest man and now owner of $1.5 billion worth of casinos in North America and three new casinos in Macao, China – get out blackjack! Open a wealth management business. The margins are better. Sell those media assets to private equity, by all means. But then take the money and then open your own private equity fund in China, list it on the market, and watch your money multiply exponentially over the next year.

   The Chinese clearly don't need any stinking casino to gamble in. They've got the world's greatest casino going in Shanghai and Shenzhen.

   How will all this end? There can't be any doubt. The rich will sell at the top and get out of town before the whole thing blows up. If you aren't paying attention to these sell signals now, you will be painfully surprised later.

   In China, we can't wait to see if the stock market top blows the roof of the political stability the government values so much. Think about it; millions of Chinese will have gone from the farm to the penthouse to the poorhouse, all in less than one generation.

   And while the newly broke nouveau riche try and figure out what happened, the really crafty government bureaucrats who own shares in state-run companies will sell their shares and move to Paris or Zurich – the ultimate retirement destinations of civil servants who rip off the public.

   There they will buy expensive handbags, smoke fine cigars, and enjoy Paris in the spring time. Singapore and Dubai are also gaining in popularity, thanks to increased private banking services that don't ask questions about where money comes from, as long as there is enough of it.

   Meanwhile, back in China, the Shanghai exchange is at least warning investors that buying stocks at 46 times earnings – the stocks that have earnings that is – is not a good idea. Apparently, there is a whole class of stocks on China's stock market called 'special treatment' stocks. China's Xinhua news agency reports that: "Special Treatment (ST) stocks...are shares in companies that have failed to earn profits for two years running or have been fingered for false accounting."

   Chinese investors can't get enough of these Special Treatment shares. Xinhua says the ST shares "have been darlings of speculative investors of late because of their capacity for sharp gains. An official with the SSE said small investors are vulnerable to irrational market fluctuations caused by rumors and hype."

   But bubbles are all about rumors, hype, and hope. That's really what a bubble is anyway: a bull market in hope. No one wants to know about risks in a bubble. Instead, people want more stocks to buy.

   Perhaps that's why officials from Nasdaq are so interested in China's stock market right now. "Nasdaq is working closely with the Chinese authorities to open a representative office in Beijing," Xinhua also reports.

   The boys at the Nasdaq certainly know how to keep a bubble going. You give people what they want, more shares! The trouble is, those same people seem to forget about price.

   Some people like paying high prices. As Tim Harford showed in his book The Undercover Economist, there are some customers who pay more for a thing not because the thing is better, but because the customer simply wants to pay more so that everyone can see that he's paid more.

   A Timex will do as well as Rolex. But a Rolex not only tells the time, it tells everyone who sees you that you can afford a heavy, expensive time piece on your wrist.

   Granted, it's not a strategy of frugality. But as Harford writes, "People who can afford more are usually people care less about price." In economic terms, some people are price insensitive.

   The trouble is, Chinese savers can't really afford to be so insensitive. China's stock market could do with a little Oprahfication, an increased American-style national sensitivity. This way, the people who can least afford it might be less inclined to pay for stocks with no earnings and no future. But sensitivity is not one of the defining characteristics of a mania.

   Like the sub-prime mortgage defaultees in the States, Chinese savers are the last folks in the door of a bull market gone wild. In this case, it's the global equity melt up. And Chinese savers have become the marginal investor in global capitalism. They've brought plenty of punch for the bowl. But as usual, the marginal buyer is last to the party and has most to lose.

   The key to keeping the whole thing running up until 2008 is for Chinese liquidity-indeed all of global liquidity-to be directed into more assets so that the boom isn't so transparently obvious, being confined to just a few sectors, like the Nasdaq technology-media-telecom boom was. These means, you guessed it, more funds, and more packaging and repackaging of assets.

   Whether this makes anyone other than investment bankers and brokers rich...we'll see. But it reminds us of the investment classic about the 1920s written by Fred Schwed. A foreign visitor to New York was given a tour of Manhattan by an investment professional. He took a look at all the yachts of the Wall Street money men and naively asked, "Where are the customers' yachts?"

   The customers don't have yachts, doofus. They have brokerage statements. In a bull market, those statements look good. Afterwards...well, they still have the brokerage statements.