The Investment Scientist

An Overdue Correction

Posted on: June 5, 2007

Yesterday morning, I read the news about the overnight 8.6% drop in Shanghai Stock Exchange Composite Index (SSEC). As I just finished the reading, I got a call from a client of mine who just returned from a trip to Shanghai. Here is what she told me. While she was in Shanghai, her brother, who was (and mostly likely still is) knee-deep in the stock market, told her to dump all her stock investments in the US and move her money to Chinese stocks instead. She was very tempted. Then she got on the flight back to the US, took a long sleep, and got a call from her brother. In addition to making sure she is safe and sound, he also told her that he had just lost 50% of his money in the stock market correction. What a difference 24 hours can make!

Just 20 days ago, I wrote “The unbearable lightness of Chinese stocks“. The article was to make a case that there is a bubble in the Chinese stock market. Chinese investors had the blind faith that the government would not let the market fall leading up to the 2008 Olympics, which will be in Beijing. By then the bubble would be so big, the repercussion of its bursting would be in the same magnitude of the Great Depression. Shortly after I wrote that, 10 days to be exact, Alan Greenspan came out with the same warning. (See the BBC report here.) Apparently, some Chinese officials took heed of Greenspan’s warning and the “stamp” tax for stock transactions was promptly raised to 0.3% from 0.1%, ostensibly to stamp out stock flipping. The action also sent a signal to the market that the government would not necessarily support stock prices leading up to the Olympics. In a country where government intention is still paramount, that signal took the wind out of the sail of the stock market, at least for the moment.

Since the tax hike, SSEC has corrected close to 20%. This is well overdue. As a matter of fact, the sooner the air is taken out of the bubble, the better. A prolonged correction of another 20% might bring some balance to the market and some sense to the investors. Should the market recover lost ground within one or two months, that would be a bad sign. We might have to steel ourself for an eventual 70% to 80% crash!

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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