Bubbles Continued....

Further to yesterday's post, I just learned today that there are no instruments available to investors in Mainland China to short equities, in contrast to most other major markets.

The lack of instruments for shorting equities increases the likelihood of a bubble, for the following reason. If I believe that the market will rise, I can easily place my "bet" by buying equities. In contrast, if I believe that the market will fall, I can also also place my bet, by shorting equities. If there are equally efficient means for placing bets on either side of the market, then the share price should reflect the overall beliefs of the market, and, as long as markets are reasonably rational, equity bubbles should be rare.

My complaint in yesterday's post was that there are more efficient instruments available for investors to bet on increasing equity prices than falling ones. As a result, prices tend to reflect more the beliefs of the optimists, and less the beliefs of the pessimists. It's even worse than that: knowing that the market will continue to disproportionately reflect the beliefs of the optimists means that even rational pessimists will be more likely to invest in equities, despite their pessimism, because the possible gains from market growth exceed the possible gains from market contraction. So equity price bubbles last longer, and have larger real effects when they eventually burst, all because of a lack of efficient instruments to short the market.

Now I learn that in Mainland China, the problems are even worse. There are simply no tools available to short the market. Thus the most that pessimists can do to reflect their pessimism is close their investments and remove their money from the market. As long as there are enough optimists remaining, the market will continue to grow. It's only when the optimists become pessimistic that the market can meaningfully correct.

Combine that with a market consisting of millions of novice investors, who have not experienced any major market falls. In the West, we know that share prices fell about 90% in the Great Depression. On October 19th 1987, the Dow dropped 22.6% in a single day. These events are part of our consciousness; we understand the risks of investing, knowing that while returns are there to be made, they are not guaranteed.

Is the same consciousness present in the Mainland Chinese investors? Investors who are willing to pay on average 3 times the price for A-shares than investors in Hong Kong pay for the equivalent H-shares? I fear not.

The possible consequences- economic, social, and political- of a substantial correction in Mainland share prices are staggering. Just to bring the A-share prices in line with H-share prices would require a 60% fall in Mainland share prices. But the high A-share prices likely increase the perceived value of the H-shares, so any major correction could be even larger than that.

For a optimistic outlook, check this Economist article (thanks to Mike for the pointer). If you want more pessimism, check this bloomberg article by William Pesek.