When children put their hands in the fire, they learn from the painful experience not to repeat that dangerous action. This, at least, was the sensible notion of philosopher David Hume.
Investors appear slower-witted than Hume’s toddlers. After speculative booms, euphoria commonly returns, only to be followed by a second collapse. China’s overheating stock and property markets provide a prime example of this “echo bubble” phenomenon.
In the two years before it peaked in October 2007, the Shanghai composite index rose fourfold. Subsequently, the market shed more than two thirds of its value. By early August, however, Chinese stocks had doubled from their trough values.
Market bubbles are generally accompanied by rapid credit growth. During the first half of this year, Chinese banks lent more than $1 trillion, equivalent to roughly one quarter of the country’s GDP. Senior Beijing policymakers have acknowledged that much of this lending has seeped into the property and equity markets.
Turnover in stocks has returned to bubble-era levels. On July 28 the value of A-shares traded in China — $63 billion — exceeded for the first time the combined turnover of the London, New York and Tokyo stock exchanges. Daily volume on the Hong Kong Stock Exchange, where many Chinese companies are listed, has doubled from its March low and has been running at about four times the average levels of the past decade.
Many Chinese companies have dual listings in Shanghai and Hong Kong. These shares have an identical economic value. In theory, they should trade at the same price. In fact, the premium on the Shanghai-listed A shares provides in indication of market sentiment. The A-share premium had doubled since the doldrums of last year and is not far below the 200 percent levels last seen in 2007.
Initial public offerings are also back in fashion. The July flotation of Sichuan Expressway Co. was more than 400 times oversubscribed. Shares in the toll road operator climbed threefold on the first day of trading. One analyst calculated that at its height the company was valued at $290 per square meter of asphalt. Valuations for the overall market have also returned to heady levels: The Shanghai composite recently reached 33 times normalized earnings.
The arrival of new entrants is another reliable barometer of market euphoria. By late July nearly half a million new brokerage accounts were being opened in China each week.
Corporate insiders appear to understand where this game is headed. Companies are spinning off subsidiaries to capitalize on inflated valuations. Stock sales by insiders have climbed as well. “When the ducks quack, feed them” is an old Chinese business maxim.
The real estate market is also buzzing. The authorities have instructed banks to lower lending standards on mortgages and to provide more second mortgages, which presumably are being used to finance speculative property purchases. Despite anecdotal evidence of low occupancy rates in new apartment blocks in Beijing and elsewhere, residential sales have picked up strongly. The house price index of several major cities is up 13 percent since the February low, according to John Makin of the American Enterprise Institute. A Morgan Stanley report suggests that home prices in several leading Chinese cities already exceed ten times average household incomes.
Commercial real estate developers are involved in a frenzied land grab and have been paying record sums for land in Shanghai and Beijing. The Wall Street Journal recently observed that Beijing property prices have returned to levels last seen a couple of years ago. Yet it is widely acknowledged that office space in the major cities is superabundant. Jack Rodman, a former Ernst & Young real estate executive, reckons that Beijing’s central business district has a vacancy rate of more than 4 percent. Rodman also claims that asking rates for new offices have fallen by half.
The deteriorating fundamentals of the Chinese economy worry many observers. Exports have plummeted. Economic growth is being driven by ever-rising levels of investment, notwithstanding evidence of serious industrial overcapacity. State-owned enterprises are rushing to build infrastructure projects of doubtful economic viability.
Yet Wall Street is once again playing the greater-fool game, often quietly acknowledging that a mania has developed but unable to resist the lure of quick profits. “When will the music stop?” one brokerage strategist asked recently about the Chinese stock market before advising clients, “Don’t leave the party too early.” Haven’t we heard that somewhere before?
What explains the echo bubble? James Montier, a behavioral finance expert, has argued that investors suffer from “conservatism bias.” After the bubble bursts, investors’ expectations remain anchored in the bubble phase. They are used to excessive valuations and easy profits.
Nobel economics laureate Vernon Smith has demonstrated in classroom experiments how momentum traders can push share prices away from fair value. Smith found that one crash was not sufficient to change behavior. Traders become prudent only after a second market collapse. The motto of the broken speculator might read: “Twice bitten, thrice shy.”
There are other possible explanations for echo bubbles. Interest rates are generally lowered after a bust, as has been the case in China. Moral hazard also plays an important role. The authorities take actions to offset the unpleasant consequences of a speculative bust, but by reducing the pain of reckless behavior, they encourage its repetition.
Today many investors are betting that Beijing will continue driving the economy forward while preventing future market declines. Yet a similar belief in the power of governments to support inflated asset markets has accompanied many frenzies, starting with the South Sea Bubble of 1720.
A survey of 12 such events — from the British railway mania of the 1830s to the Saudi Tadawul bubble of 2005 — shows that echo bubbles have common characteristics. The typical one lasts longer than a bear market rally but not as long as the bubble that preceded it. On average, echo bubbles climb for ten months from trough to peak. Furthermore, the echo is proportionate in size to the earlier boom, averaging roughly one third of its size.
So how does China’s echo bubble measure up? Well, the peak-to-trough decline of the Shanghai composite was 67 percent; the dozen bubbles under consideration also fell by two thirds. Since the trough, Chinese stocks have doubled, thus exceeding the average echo bubble by about 10 percentage points. The Chinese echo bubble is about one third the size of the preceding boom, which is in line with the historical ratio.
The greater fools of Wall Street who argue that the Chinese market will continue rising for months to come might consider the following: Echo bubbles normally fade when valuations have climbed to about one standard deviation above the mean. This is roughly the level that Chinese stocks reached earlier this summer. The Shanghai market had been rising for ten months by August. By coincidence, this is also the average length of the dozen former echo bubbles.
Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.
