Research Affiliates: The China Syndrome: Lessons From The A-Shares Bubble

September 21, 2015

The following is part of ongoing contributions from Reseach Affilates.

The Chinese stock market rallied more than 150% as the Shanghai Composite Index rose from 2,037 at the end of June 2014 to its peak of 5,166 in June 2015. Many market commentators, most notably Bill Gross, called it a "stock market bubble" and predicted a collapse. However, it bears asking, "What is a stock market bubble and how is it different from just a run-of-the-mill bull market?"

Simply stated, a bubble is an irrational bull market, where prices for stocks have run up much more than can be justified by improvements in the underlying corporate fundamentals. Classic stock market bubbles were the Japanese bubble during the late 1980s and the U.S. tech bubble that occurred in the 1990s (see Figure 1). A characteristic attribute of a bubble is an unjustifiably high price-to-earnings multiple (P/E) for the market.

China Syndrome

For a larger view, please click on the image above.

For the average investor, a bubble market isn't bad in the short run. Investors are wealthier than they were a year ago and better off than their colleagues who did not invest in the stock market. The problem is that bubbles eventually burst. After the boom, the bust is psychologically painful to an investor who rode the Chinese A-shares market from 2,000 to 5,200 and then back down to 3,000 (see Figure 2).

China Syndrome

For a larger view, please click on the image above.

Nonetheless, even after a 40% decline (as of this writing), this hypothetical buy-and-hold investor earned a 50% return in 12 months. The naïve investors who were lured into the market near the peak suffered real pain in the form of large financial losses. In fact, many investors who bought stocks on margin have seen their portfolios wiped out because of the leverage. As we have shown elsewhere, the average retail investor's portfolio return is substantially below the buy-and-hold return on the market index (Hsu and Viswanathan, 2015). This return gap is especially large during bubbles and crashes.

It is often joked that a bubble market is where naïve investors feel like financial geniuses.1 That illusion inevitably destroys wealth. Hsu, Myers, and Whitby (2015) show that the less sophisticated an investor is, the larger his return gap over time. The enormous return gap that emerges for average retail investors is one of the most undesirable aspects of a stock market bubble.


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