TheGreatChinaBubbleLessonsfrom800YearsofHistory.docx
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TheGreatChinaBubbleLessonsfrom800YearsofHistory.docx
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TheGreatChinaBubbleLessonsfrom800YearsofHistory
TheGreatChinaBubbleLessonsfrom800Yearsof
History
Whenspeculationhasdoneitsworst,twoandtwo
stillmakefour.--S”amuelJohnsonSummary:
Clusteringextremereturnsandexcessiveturnoverarehallmarksofabubble.Theaverageholdingperiodoftradablesharesin
Chinaisaboutaweek,comparedwithaholdingperiodoftwoweeksatthepeakofTaiwanesebubblein1990.
Everyoneisbusylookingforthegreaterfool.Asextremereturnswithsmallpossibilitypilesup,gainsmustacceleratetocompensateexcessiveriskundertaking.Buttheprobabilitytosustainsuchexcessdiminishes,too,muchlikebeingdealtstraightflusheveryhand.Historysuggeststhatthecomingsixmonthswillbeacriticaltime
crash.
windowtomonitorforpotential
Arationalbubble:
Itisplain
thatChinaisinabubble.WithShanghairapidlyrisesabove5,000points,aprevalentstrategyamongstprofessionalfundmanagersistofollowthecrowd-butfleeifthemarketeverslightlyturnssour.Beholdtheworld-recordturnoverthatismorethandoublethatofthe
US,andeasilydwarfsanyothermarkets.Explodingvolume,concurrentwithsignificantdailyturnover,arethehallmarksofabubblethatislikelyinitsadvancedstage.
Nowthequestionishowhighitwillgo,howmuchlongerbeforeitgobust,andhowwillthisfiascoend?
Therearenoeasyanswers.Weareexperiencingarationalbubblethat
'sstockswithperpetuity,
arisesfromarationalvaluationformulainmodernfinance.
Recallthatifwevalueacompanythedifferencebetweendiscountrateandgrowthrate
determinesthecompany'svaluationmultiple.Orsimply
P/E=1/(r-g).Thesmallerthedifferencebetweenthediscountandgrowthrate,thehigherwillbethemultiple.
Forinstance,ifthedifferenceis1%,thanthecompanyshouldbevaluedat100times.In1938,VonNeumanproposedanextremescenario:
whatifdiscountrateequalsgrowthrate?
Hepositedthatinabalancedgrowtheconomy,growthrateisalwaysidenticaltointerestrate,or
discountrate.Inthisextremescenario,stock'svaluewill
growthstock
alwaysbeinfinite.Andsocomestheparadox”.InaneconomywithrapidlyfallinginterestratesuchasChina,itcanbedemonstratedthatvaluationmultipleshouldbeveryhigh,oreveninfinite,withthegap
betweendiscountrateandgrowthratenarrowingquickly.
Aslongasinterestratefallsfasttowardsgrowthrate,valuationcanbehighevenifgrowthcontinuestoslow.
Thisparadoxseemstobeabletoexplainthecurrentdilemma:
theriseinChinesemarkethasrationalroots,butseeminglyirrationaloutcomes.Yettherearenomagicbeansinthemarket.Weneedtoknowwheretheboundarywillbeformarketprices.Manybeforeushadtriedtodefinetheboundaryandfailed.JustbeforetheGreatCrashin
theconsensusof
October1929,JosephStaggLawrence,arenowned
Princetonprofessor,proclaimedthatjudgmentofthemillionswhosevaluationfunctionsonthatgreatmarket,thestockexchange,isthatstocksarenotat
presentovervalued”.“Whereisthatgroupmoefnwiththe
”heinquiredfurther.
all-embracingwisdomwhichwillentitlethemtovetothejudgmentofsuchintelligentmultitude?
Whileweallknowhowthatmovieends,researchinbubblehasprogressedgreatly.Evenso,wehavenotseenamodelthatcanconsistentlypredicttheburstofabubbleotherwisewewouldn'tbeallsittinghere.Inscience,weuse“Occam'sRazor”,ortheLawofParsimony,todeterminethepracticalityofatheory.Thesimplerthe
theory,andthelessvariablestocontrolforfutureprediction-thebetter.Forthispurpose,thefamousLPPLmodelisalittletoocomplicated,withsomewhatsporadicpredictionsuccess.Rather,wewilllookintohistorytofindsomecluestothefuture.Clusteringextremereturns,excessiveturnoverarehallmarksofabubble;thecomingsixmonthscritical:
Wehaveinvestigatedacombined800yearsofglobalfinancialdata,from17thcenturyUKstockmarket,to18thcenturygoldandsilverprices,andonto19thcenturyUSstockmarkettodiscerntheordinateswithinbubbles.Ourquantitativeresearchshowsthatatypicalbubbletendstotakearoundfiveyearstodevelop,andexhibitsclusteringextremereturnswhenapproachingitspeaks.Ingeneral,whenreturnconsistentlyexceedstwostandarddeviationsfromitslongtermlogarithmicreturn,abubbleisforming.Anditnormallytakesaboutanothersixmonthsbeforethebubbledeflates—orevenburst.Withthismethodology,wehaveidentified26bubbles,21
smarket
incidencesarecorrect.ThefollowingchartsshowtherelationshipbetweenextremereturnsandChinaindex(FocusChart1).Wecanseetheobservationsaforementionedclearlydemonstratedinthesecharts:
1)clusteringextremereturnsleadingthewaytothepeakofbubble;2)theoccurrencesofextremereturnstendtohappenapproximately6monthsaheadofthepeak;and3)theseextremereturnsbelongstothetop5%ofthereturndistribution.FocusChart1:
Extremereturnstendtocluster6monthsbeforepeaks;95%ofreturnislowerthancurrentlyobserved.Thereasonforclusteringextremereturnsnearingthepeakofabubbleisintuitive.Tradersareconstantlyassessingwhethertostayinthemarketbycomparingthereturnofholdingstocksintothenextperiodversuscashinginnow.Asthemarketrises,higherreturnsbecomelesslikelyonthedistributiontree.Thus,theexpectedreturnthattradersrequiretostayinthemarketmustsoartocompensatefortheeverdwindlingchanceofwinningit,asseeninthenear-verticalclimbofthemarketindex.However,asthesesmall-probabilityeventscontinuetoaccumulatenearthepeak,theprobabilityoffurther
gainsgrowseversmaller-muchlikebeingdealtastraightflusheveryhand-tilltheprobabilitybecomessosmallthatacrasharrivesinevitably.Ifthisexplanationholdswater,thenwemustseemarketturnoveracceleratingconcurrentwithextremereturnregistrationnearingmarketpeaks-as
itisnow.Thisisbecausetradersstarttoconstantlyassesstheriskswiththeirpositionswithinanever-shortenedtimespan—attemptingtotimetheirexitwithperfection.Ifacceleratingturnoverandclusteringextremereturnsareconcurrent,itshouldleadthepeakbyaroundsixmonthsaswell.Thisisindeedthecase(FocusChart2).When
ahallmarkof
calculatedonafree-floatadjustedbasis,Chinesemarketaverageholdingperiodisaboutoneweekintensespeculativetradesinthemarket.Everyoneisbusylookingforthegreaterfool.Notethatattheheightofthe
Taiwanesebubblein1989,everyavailableshareontheexchangechangedhandsclosetotwentytimesperannum.
Thatis,thefree-floatsharesonTaiwaneseexchangechangedhandsevery15daysonaverage.FocusChart2:
Free-float-adjustedsharesturnoveralmost3times/month;
averageholdingperiodisabout1week.Shanghaicanclimbto6,100:
WherewouldtheChinesemarketpeak?
Thisisamoredifficultquestiontoanswer.AChinesemarketadagedictatesthatoneshallneverpredictthepeakindexlevelduringabubble.SirAlanGreenspanoncesaid,“Bubblesgenerallyareperceptibleonlyafterthefact.
Tospotabubbleinadvancerequiresajudgmentthat
hundredsofthousandsofinformedinvestorshaveitall
wrong.Bettingagainstmarketsisusuallyprecariousat
best.”Mostwouldratherlettheirreputation
fail
conventionallythansucceedunconventionally
”.Wehave
hadourfairshareoffailureinpredictingthepeakofthe
marketthisyear.Whenwewroteouroutlookpiecetitled
China2015:
ABubblyNation
”forBloeormgbonJanuary
29,weforesawabubbleformingintheChinesestock
marketin2015.Yetwehadsetourindextargettoo
conservativelyat4,200bycomparingbondyieldversus
earningsyield,eventhoughthemarketwasataround
3,100then.Afterthemarketblewpastourtargetof4,200,
werecognizedthestrongupwardthrust,withoutsettinga
specifictarget.Thistimearound,insteadofusingthe
traditionalPE,PBmultiplestovaluethemarket,wehave
usedtheMarketCap/GDPratio.Wenotethatthemarket
waswillingtopay~1.2unitforeachunitofGDPearnedat
thepeakofthe2007bubble.Thisratio,observedatthe
peakofthebubble,isareflectionofmarketsentiment,and
canbeusedasareferencetoevaluatethecurrentbubble
(FocusChart3).Furthermore,inothercountriessuchas
theUS,thisratioismeanreverting.Ifthisrelationship
continuestoholdinthecurrentmarketcycle,thenthe
ShanghaiCompositecanriseabove6,100.FocusChart3:
MarketCap/GDPissoaring,andisapproachingitspeakin
Nov2007.Thisratioismean-revertingintheUS.Monetarypolicywillcontinuetoease:
Incidentally,Chinarealeffectiveinterestrate,aftertakingintoaccountconsumerandhousepriceinflation,remainselevateddespiteroundsofinterestcuts.Thatis,Chinawillcontinuedownitspathofmonetaryeasingtoreallylowertheinterestburdenofthe
Chineseeconomy.Therealeffectiveinterestratetendstoleadthemarketbyaroundsixmonthsaswell,coincidingwiththetimeframeidentifiedinthevariablesdiscussedabove(FocusChart4).FocusChart4:
Realratestillelevated,hintingatfurthereasing;ItleadstheShanghai
Compositeby~6months.
TheGreatCrashin1929hasdemonstratedbubbleburstingisnotoriouslydifficulttotime,andafinancialcollapsehasseldomhappenedinbadtimes.Forinstance,macroeconomicflowswereingoodshapejustpriortothecrash.Hoover'selectionintotheOfficepriortothecrashwasalsosupportivetoanoptimisticpoliticalmood.Indeed,thepreeminentHarvardEconomicSocietyproclaimeda
fewdaysafterthecrashthataseveredepressionsucha
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