Asian bubble trouble

Yes I've joined the chorus of pundits warning of the impending bubble that is reaching exponential proportions in China. I came across an interesting article over at Market Clues on the state of the Shanghai stock market worth pondering. If the following doesn't sound like a bubble I don't know what does.

China Stock Bubble About to Burst

It appears that the bubble in the Chinese stock market is finally becoming a concern as Goldman Sachs is warning that:

"It is now a critical time for the government to take action and prevent the excess from building up further."

Here are some interesting factoids about the Chinese stock market:

* The total value of all stocks on the Shanghai Exchange exceeds the value of all other Asian stock exchanges combined -- including Japan, the second largest stock exchange in the world.

* The Shanghai Index has quadrupled in the last 22 months.

* PE Ratios are in the 40-50 range.

* Goldman Sachs economist Hong Liang said new stock account openings in the month of April totaled 4.79 million, exceeding those of 2005 and 2006 put together. About 17% of total accounts were opened in the past four months.

* Beijing is aware of the risks, and over the weekend, Gov. Zhou Xiaochuan of the People's Bank of China told reporters that he, too, is concerned about a possible bubble forming in the stock market.

If it were possible to let the air out of a bubble slowly, of course that would be the right course of action. However, at this stage of overvaluation, that's not possible. Probably the only way the government could prevent a crash is to shut the market down completely for some period of time (say, a few years). That isn't really practical and would likely be a cure worse than the disease. There's really nothing good that can come out of the situation, so just expect a crash sooner or later.

The last time the Shanghai market had a 10% correction in February, it quickly pulled the rest of the stock markets around the world down with it. Since then, just 3 months later, Shanghai is now 33% above the level it reached before that correction, after having pulled stocks higher along with it worldwide. No doubt, a much large correction will happen this time and it will have a much stronger impact on the rest of the planet's stock markets. In fact, it may have already started. And, it will come at the worst possible time for the US stock market, which has been pushed to an extreme of overvaluation by Yen-carry loans to fund private-equity buyouts of public companies and massive share buybacks by corporations.

The US market fell sharply Thursday. More troubling was the fact that option speculators bought call options on the dip. Normally, option specs buy puts on dips because they expect the market to continue down. Only very rarely are they so bullish as to actually buy calls, expecting the market to immediately turn around and rally to a new high before those calls lose a substantial amount of value (options are a wasting asset which decay with every tick of the clock and if a market doesn't move quickly in the "right" direction, they fall in value). In fact, we can only recall one other time when the option speculators bought calls on a dip. That dip was the one which followed the absolute high in the S&P 500 Index in March 2000. If the market is able to rally back here to a new high -- and we certainly wouldn't be surprised by such behavior -- it would indicate that the top being built now is a larger degree top than even 2000. And, of course, we know that last top was followed by an 80% decline in the NASDAQ.