After an impressive yearlong stock-market rally, China’s stocks are retreating and showing signs of an asset bubble burst. Since late 2014, the Shanghai Composite Index jumped around 100 percent, but has now lost approximately one-third of its highest value in just a few days.
With this, the government of China has been exerting all efforts in order to support the markets. The interventions that it has made also enable the well-connected Chinese to cash out without losing too much.
Some people may be wondering: Why did market participants believe that the stock market of the Asian nation was destined to move to soaring high levels, even as some market observers and analysts have observed all symptoms of a bubble? For years, economists and market experts have been pondering on this question. Although there are no exact answers, this article will present some of the possible explanations.
According to some analysts, a stock-market bubble can be pumped up by speculation. This happens when market participants purchase assets for more than they think the assets are worth, because the investors believe that they will be able to sell the assets at a greater price. Obviously, if all market participants think rationally, speculation wouldn’t exist. However, if the market is dominated by irrational investors, rational ones will be overwhelmed and force them to buy into the market bubble rather than trade against it. A huge chunk of the Chinese stock market is held by individual investors, hence, it is probable that irrationality has taken over and speculation ensued.
In relation to speculation, herd mentality may also be another possible explanation for China’s bubble. For instance, when the prices of stocks suddenly skyrocketed, some investors believed that there is a reason behind this huge rally. When more market participants pile in, the stock prices will climb even higher, and there will be even more buyers. It is possible that Chinese investors have jumped into the markets for the simple reason that everyone else was doing so. Aside from the mentioned possible reasons, investors may also be inclined to extrapolative expectations. Market participants tend to use the past in predicting the future, and interpret movements in prices as trends that can be expected to resume. Stock-market investors in China may have wrongly assumed that the rallying of prices was a trend that could be expected to continue. There are a lot of possible reasons for the existence of market bubbles. Although there isn’t a consensus yet, investors can look for signs and symptoms that can help them identify if there is a heightened risk of a bubble.
Regulatory Change
One of the most common ones is overvaluation relative to historical price to earnings multiples. The next one is changes in regulations, which allow a sudden influx of new investors into the market. Yet another sign is the presence of a compelling story that explains why the present time is different. It is somehow intended to influence people into thinking that the recent increases in prices will continue on forever. Though this isn’t a foolproof way of identifying a market bubble, spotting these signs should prompt you to be more cautious. As for China’s stock market, if you made the mistake of jumping into that bubble, it’s most probably too late by now.