While Western news has been dominated by the “Greek Crisis,” an extremely important and cautionary tale is unfolding in China. Loosening restrictions on outside investment into mainland Chinese shares have created a bull market of epic proportions. The Shanghai index returned well over 100% over the last year. The situation was almost reminiscent of the late 1920’s in the United States, with individuals from all walks of life getting involved in speculation on the belief that prices just had to keep going up. Even worse, many of these unsophisticated market participants used aggressive margin policies to lever up and speculated in stocks trading at well over 100 times earnings in some cases.
The Shanghai index is now down about 25% from the highs having entered into a bear market. To quell social unrest, the Chinese government is already taking steps to attempt to bolster confidence in the markets and create higher prices. The key thing to keep in mind is that price movement alone is not an adequate reason to invest in a stock. Investing in a stock is buying a fractional share of a business. When buying any business, it is important to understand the financial condition and future earnings prospects of the Enterprise. Investing is by definition a long-term enterprise as predicting short-term swings in prices is much more akin to speculation, which we do not do at TTCM.
History is littered with cautionary tales of speculators that have gone bust through getting swept up in the euphoria of a bull market. I don’t see this type of bubble in U.S. equities, but there are areas that are extremely frothy. Valuations in many sectors do not offer a strong margin of safety, but there are some notable exceptions such as financials. Below is a link to a WSJ article, which describes the situation unfolding in China. I hope that you enjoy!
How Chinese Stocks Fell to Earth: ‘My Hairdresser Said It Was a Bull Market’