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Searainbow Holdings Corp - a stock highlighted in a recent Bloomberg article as amongst the most expensive stocks trading on the Shenzhen Exchange in terms of PE - is priced at around 10,000X earnings. Clearly it is a product of the bubble in Chinese equities. The thing is though, that even when this stock was trading at a PE of 5000X a little while back, it would have been classified as expensive even then. Yet it continued on, managing to double in valuation over a short time. Therein lies the difficulty in calling bubble tops. On the one hand, most are willing to acknowledge the crazy moves we’ve had as excessive. On the other hand, if we are able to continue on to double our money again from here, why ‘look a gift horse in the mouth’? Two things though - perhaps three if we were to include Bill Gross – which can prick the Chinese equity bubble could soon happen here.

What to watch for

The first is that local brokers there may start removing or restricting the availability of funds for stock margin lending. Even the restriction of lending to a certain list of stocks - something similar to our locally dreaded ‘designated lists’ introduced from time to time by Singapore brokers to temper the frenzy of penny stock trading here - may have a reversal effect on the trajectory of share prices. When these sheets of ‘designated’ stock lists are circulated, dealers are often not allowed to place new buy orders on these names, or are restricted to the amount of shares that they can buy. Often purchases here require cash deposits before anything may proceed. Credit control departments are vigilant over this process because in times of such exuberance, credit risks become a huge worry if things take a sudden turn. Whenever this happens, stocks, especially names with the highest margin lending outstanding, get knocked the hardest as margin selling follows. This is because without the ability to borrow money nor to extend the time before having to pay for one’s purchases (contra in Singapore stocks trading speak), buyers for these securities prefer to sell their positions as they usually do not have sufficient funds to pick up their bets. During lunchtime yesterday, it was reported that Golden Sun Securities Co removed the ChiNext Index stocks from its list of shares eligible for margin trading. This triggered an immediate sell-down of the Chinese equity markets when trading resumed after lunch. Well, at least momentarily anyway. The Shanghai Composite Index slid as much as 5% before settling down. It then whipsawed 180 degrees to hit positive territory later, closing up almost 0.7%. The China A50, even more spectacular, had a round trip move of more than 1000 points!

Classic bubble

This behaviour represents a classic, liquidity-fueled bubble scenario. Yesterday’s moves by Golden Sun however, signal that the end may be near for this run. Other brokers may follow the lead of Golden Sun, balancing the sacrifice of active business in favour of managing the risk of getting caught and stuck with losing bets that may go bad if things take a sudden turn south. The other thing that may also deflate the bubble here, besides Mr Gross off course, is for the regulator CSRC or even PBOC to come in with a blanket restriction on margin trading. Now if that were to happen, the destruction of this rally would most definitely be much more crippling.
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