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, though, is 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. The Chinese equity bubble Herein 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, if we are to continue on to double our money again from here, why ‘look a gift horse in the mouth?’ Two things could happen here, which can prick the Chinese equity bubble: The first is that local brokers may start removing or restricting the availability of funds for stock margin lending. Even the restriction of lending to a certain list of stocks – similar to our locally dreaded ‘designated lists’ introduced from time to time by Singapore brokers to temper the frenzy of penny stock trading – 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 turn suddenly. Whenever this happens, stocks, especially those with the highest margin lending outstanding, get knocked the hardest as margin selling follows. This is because without the ability to borrow money or 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. Over a lunchtime in June, it was reported that Golden Sun Securities Co – a local broker in China – removed the ChiNext Index stocks from its list of shares eligible for margined trading. This triggered a momentary sell-down of Chinese equity markets when trading resumed after lunch. 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 spectacularly, had a round trip move of more than 1000 points. Classic bubble This behaviour represents a classic, liquidity-fueled bubble scenario. That day’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 wild card The other thing that may also deflate the bubble here, is for the regulator CSRC or even PBOC to come in with a blanket restriction on margined trading. Now if that were to happen, the destruction of this rally would most definitely be more crippling. Caveat emptor! CMC Markets is an execution only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

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