360 Degrees on China's Selloff

Why We Should Worry About China
By Rev Shark
5/30/2007 8:08 a.m. EDT

"Those that set in motion the forces of evil cannot always control them afterwards."

-- Charles W. Chesnutt

The indices are under some pressure this morning as Chinese stocks dived 6.5% following the increase in a "Trading Tax," which I discussed yesterday. Although the tax is quite small and mostly irrelevant in view of the level of gains that have been produced in the China market, it is significant because it indicates the Chinese government's intent to cool off stocks.

No one seriously questions the fact that China stocks -- particularly the Shanghai "A" shares -- are in a speculative bubble. The A shares are traded in a closed market and have performed far better than their counterparts on the Hong Kong exchange. The A shares are up a whopping 74% so far this year following a rise of 126% last year. The average PE is over 40 but the most worrisome aspect of the market is that new accounts are being opened at a staggering rate of 300,000 a day, and stories about average individuals sinking all their assets into the market and giving up jobs to play the market are appearing every day.

The problem for the Chinese government is to cool speculation without killing the market. They don't want stocks to go down; they just don't want them to go up at such a ridiculous pace. Unfortunately, it is nearly impossible to control markets in that manner. Once the beast is released there is no way to stop it. At times things will become excessive and eventually some folks are going to suffer some real pain.

It is obvious Chinese officials are trying to keep things from getting too hot so that when the inevitable correction comes the pain won't be quite as bad. One additional issue that complicates things is the widespread belief that China is anxious to paint a positive, progressive picture as host of the 2008 Summer Olympics. A stock market crash would be a very shameful event and many believe that will keep efforts to cool the stock market somewhat contained.

China is important to our market because it has helped keep worldwide speculation perking along. Who can say that our market is too expensive when you have China trading at much higher multiples?

This morning we have a pretty good-sized hiccup in China and that is causing weakness worldwide. We had a very similar breakdown back in early February that led to a week of weakness but that was soon shrugged off and we moved higher even faster than we had been before the correction.

You can bet there will be plenty of folks looking for another very short-lived correction, but let's keep in mind that conditions are changing as we enter summer and the recent climb in the market shows some signs of stress.

We have a sharp dip indicated at the open. Overseas markets are down across the board with most of Europe trading down about 1%. Oil is stable after taking a big hit yesterday and gold is down slightly.

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