Caution: Is This Massive Chinese Bubble About To Burst?

A generic image of a pen on top of a stock chart. Credit: Shutterstock photo

The roaring 1990s brought a new phrase to the investing lexicon: "market melt-up." It is described by some as a "buy first, ask questions later" mentality, as legions of investors piggyback on a winning trade.

Yet such melt-ups invariably end badly. Once some investors start to book profits, a cascade effect takes place, where selling begets further selling. We surely saw that in evidence at the start of the past decade. From peak to trough, the Nasdaq composite index fell a stunning 78.4% from 2000 to 2002.

U.S. investors were so badly burned by that event that there is still a lingering distrust of stocks. And that's a good thing. Such caution likely means we'll stop ourselves before collectively creating another market melt-up.

Unfortunately, investors in China can't draw from past experience and are setting themselves up for the same bit of misery. Chinese stocks rose at a measured pace in 2014, but have been absolutely on fire in the past few months.

These investors have been buying shares with abandon, even in the face of an increasingly apparent economic slowdown. They aren't conducting rigorous investment analysis, but are instead simply chasing success.

This year, Chinese economic growth is expected to slow to its lowest rate in two decades. The government officially predicts a 7% growth rate, though private economists think it will be at least a few percentage points below the official forecast. China's banking system remains heavily indebted and will need further aid to stave off a rising tide of loan delinquencies.

All the while, China's population is rapidly aging -- thanks to the one-child policy -- which means that factories are now paying higher wages to lure talent. In contrast, neighboring Asian countries such as Vietnam, Bangladesh, Cambodia and the Philippines are attracting low-end manufacturing jobs away with the promise of lower wages.

That doesn't set the stage for a Chinese economic crash, but it doesn't explain why share prices should be soaring either.

Instead, Chinese investors seem to feel that they have nowhere else to invest. Chinese real estate prices have recently been falling at a 5% annualized pace (triggering memories of Japan in the 1990s), and that asset class is no longer poised to deliver open-ended annual gains. Meanwhile, Chinese investors are largely restricted from investing abroad.

Simply put, demand for shares is overwhelming supply. That demand is being exacerbated by a rapid spike in margin debt. Roughly 8% of all free-floating shares in China are owned in margin accounts, according to Australian investment bank Macquarie. That compares to just 2.5% in the United States. Borrowing funds to buy more shares can spell disaster. In the United States, a margin squeeze was one the key factors behind the rapid plunge and lingering fallout of the dot-com bubble burst.

Frankly, this is the Chinese government's fault. In September 2014, the state-run media implored people to buy stocks . After that announcement, Chinese investors opened new investment accounts in droves.

In a recent look at Chinese stocks, the Wall Street Journal interviewed a 58 year-old electrician who said ""The higher the stock prices are, the more people are buying them." This is precisely what happened in the United States in the late 1990s. I recall being at parties where crowds formed around me, asking what stocks they should buy, simply because I worked at an investment magazine. That same electrician added that "If the prices go down, no one wants to buy."

And that is the real concern here. This appears to be a game of musical chairs, and once the music stops, investors may scramble to get off the floor.

The iShares China Large-Cap ETF (NYSE: FXI ) , made a rapid move to the $50 mark in early April, but has since moved largely sideways. That could be a sign that many Chinese investors no longer want to chase stocks into nosebleed territory. What will happen when some of them decide to book profits?

In the United States, short sellers seem to see a potential sentiment shift as a clear opening. In the two weeks ended April 15 (which was reported on April 28), the short interest in the iShares ETF surged 54% to 50 million shares. The key question: will the "melt-up" resume course, burning these short sellers? Or are they one step ahead of the Chinese investing public in spotting an entry point for a big pullback? Time will tell.

Risks To Consider: As an upside risk, the Chinese government could announce a massive stimulus plan that boosts hopes that the Chinese economy can avoid a protracted slowdown.

Action To Take --> If you are thinking of buying Chinese stocks right now, then there are ample reasons for caution. These stocks aren't stratospherically priced, as was the case with U.S. tech stocks in the late 1990s. But their gains appear to be the result of a stock-buying mania and not the result of any sort of fundamental analysis. This is indeed an appealing opening for short selling, but understand that a further met-up can lead to losses, so you may want to establish an exit strategy in the event the iShares China Large Cap ETF moves above $55.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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