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Is a Bubble Forming in Chinese Stocks?
By Bill Bonner | Published  05/9/2007 | Stocks | Unrated
Is a Bubble Forming in Chinese Stocks?

When money talks, we listen. But we expect money to return the courtesy.

For many months now, we've been warning money. "You're getting a little out of control," we've been saying. "You're becoming reckless," we warned. "Watch out…you're over-paying…you're taking too many risks…you don't know what you're doing."

But Mr. Moolah never listened.

And now we're no longer listening. Why should we? The poor fellow's off his head - raving, screaming, and talking nonsense. But the lumps still pay attention.

On Sunday, three state-run newspapers in China ran cautions similar to ours. Zhou Xiaochuan, governor of the People's Bank of China, gave the people a warning; when asked whether a bubble was forming in Chinese stocks, he said 'yes.' Nothing very subtle about it.

But what do the people do? They ignore their leaders and bid up Chinese shares another 3% - to a new record high, at 43 times trailing earnings. Last year, the Shanghai Composite index rose 130%. It's up another 50% so far this year. And so many people are making so much money that they're not about to pay attention to either the Daily Reckoning or the Peoples' Daily.

The Chinese are famously frugal. They are said to save 25% of their earnings. What are they going to do with the money? The Central Bank also sets interest rates, and at the moment, savers earn just 2% on their deposits. In a country with about 5% consumer inflation, that gives them a net return of minus 3%.

So the poor Chinese are damned if they do and damned if they don't. But our guess is that a 3% loss on savings accounts will look like found money when the stock market crashes…as it is likely to do.

Meanwhile, across the broad Pacific, investors are as deaf as the Chinese. Stocks have had a winning streak not matched since before the crash of '29. Also, similar to the '29 period - stock margin accounts are up. Here's a report from USA Today:

"The NASD, a brokerage regulator, recently sent out an 'alert' to investors outlining the risks associated with margin. Through the end of March, the latest data available, the amount of debt taken on by investors to buy stocks totaled $317.7 billion. And while that was a bit below the $321.2 billion record hit in February, it still surpasses the $300 billion in March 2000 at the top of the tech-stock bubble.

"'If you're borrowing money from your broker to buy stocks, you're basically speculating,' says Chris Johnson, investment strategist at Johnson Research Group.

"A sharp rise in margin debt means investors are eager to own stocks. And such spikes are often associated with market tops, as was the case in 1929 and 2000.

"Sure, investors have a chance to boost returns by using other people's money - a technique called leverage - to buy more shares than they could on their own. But buying on margin is just another form of debt, another IOU, another buy-now-pay-later transaction.

"'We're not trying to set off alarm bells,' says Elisse Walter, senior executive vice president at NASD. 'But with margin debt (near record levels), we felt it was a good time to remind retail investors what margin is, how it operates and what the risks are.'"

Warn all you want. Money is deaf…and very dumb. Despite our warnings, the Dow has been up for five weeks in a row.

*** Should the people pay any attention to official warnings?

Didn't Alan Greenspan famously warn of 'irrational exuberance' in 1996? And didn't it turn out that the exuberance wasn't so irrational after all? The Dow went up for four more years…corrected in 2000-2002…and has been going back up ever since.

And remember when Carlos Menem, president of Argentina, told the world that it had nothing to worry about with the peso. "One peso, one dollar. Full stop." We were just there; we got three pesos to the dollar.

"When the authorities tell you to do something, you should probably do the opposite," says our neighbor, Pierre. But what if…occasionally…the authorities didn't lie? Yes, it would be a dirty trick…but we wouldn't put it past them.

*** And here's a non-warning. The National Association of Realtors says problems in the residential property market are worse than it thought. Instead of the average, existing house declining 0.7% this year as it predicted, the drop is likely to be closer to 1%, says the NAR. Not since the '30s has this happened, it noted.

And 'if it weren't for a favorable economic backdrop,' the situation would be much worse.

A one-percent fall doesn't sound to us like something anyone would worry about.

Meanwhile, foreclosures in April were twice their level in 2006. Warren Buffett says these problems are big problems for the people who are in the middle of them, but they're not likely to affect the rest of the nation.

We suppose it's a bit like being in a big battle. It's probably exhilarating and interesting - as long as you're not one of the people who gets killed.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.