This time it’s different for Chinese stocks!

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From Bocom International Holdings Co. via FTAlphaville on the ye auld Chinese share surge:

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Currently, the yield gap shown in our chart [ showing earnings yield minus bond yield in China versus the Shanghai Comp] is plunging nearing its historical extreme. If bond yield can continue to fall to the 3% range due to slowdown and monetary easing, and if the change in gap approaches once again the extremes seen at the peaks of 2007 and 2009, then earnings yield can rise to 5% from where it is now at just over 6%, taking the Shanghai Composite to above 4,000. But note that these last few hundred points are fraught with volatility.

Get ready for surging volatility: Could we have learned from the past experience during the bubble years of 2007 and 2009? Could this time be different? Academic evidence appears unfavorable in this regard. In a paper collaborated with Caginalp et al. in 2000, Vernon Smith, Nobel Laureate of 2002, established experiments on how the market deal with the bubbles from the past. He noted that bubbles, if occurred sequentially, could be formed for different reasons. The initial bubbles tended to stem from belief of a new idea, or a fad. The subsequent bubbles then were built upon overconfidence after traders had experienced the first rounds of bubble. That is, after losing money in the initial bubbles, traders then believe that they could exit the subsequent bubbles before everyone else does – with perfect timing.

This observation certainly feels familiar. Investors are finding assorted excuses to justify their holdings. Many are proclaiming index level without much thought on how their targets are derived. It is tantamount to pulling numbers out of thin air. When the dispersion of views is narrow, any failure in price momentum could unleash a self-fulfilling downswing in the market –a negative feedback loop (Abreu and Brunnermeier, 2002, 2003). Or as the great Keynes put it eloquently: “it is the nature of organized investment markets, under the influence of purchasers largely ignorant of what they are buying, and speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of future yield of capital assets, that, when disillusion falls up on an over-optimistic and over-bought market, it should fall with sudden and catastrophic force.” It is an apt description of the current market state – from almost 80 years ago.

At our farewell lunch, we discussed the market with our local friends. We had a great time toasting with a famous local rice liquor that had been maturing for over 50 years and was designated for state banquet. My host asked me how I valued the Chinese market. “Price to earnings and price to book ratios,” I said. “And they are already very high,” I added. Already slightly tipsy, I was having tea instead of alcohol. “Alas, my friend,” my host smiled. “What about Price-to-Dream ratio, Price-to-Guts, or even Price to the-Greater-Fool ratio?” I was humored, and raised my tea cup. “Let us drink to the Price-to-Whatever ratio!” “You are obviously still sober,” my friendly host reached out for my arm. “You shouldn’t be drinking tea while the rest of us are having alcohol.” I had to oblige, and we imbibed all the great alcohol before our flight took off.

And from Investing in Chinese Stocks:

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Authorities are all for it so this time it’s different!

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.