Excitement has no end this week as Chinese stock exchange has experienced a huge crash. Instead of giving you the scale and numbers for this crisis I will show you what happened with Chinese stock exchange last two years. This is typical example of investors’ behaviour. We went from long period of cheap shares then, rapid growth through pumping speculative bubble. Now we can see last phase: Panic.

Chinese stock exchange recent years was very cheap compared to its competitors in Europe, the US or other developing markets. This is because of quantitative easing and lowest in history interest rates. Against rapid climb only two – Moscow and Shanghai exchanges defended for long time.

On both of those markets the price of shares in relation to book value were on very low levels. Investing in stocks was interested only for few people that could see an opportunity in front of them. I myself must confess that I knew about that but I decided not to invest in fear of the consequences of real estate bubble bursting.

In any case, stocks hold on very attractive levels for over 3 years. It was long enough to buy them and wait patiently. Situation started to change in early 2014. Prices started to rise and catch up other stock exchanges. It was nothing surprising. Many famous names acknowledging that begin to shift their capital to Chinese market from the US or Europe.

In 2014 shares on Shanghai stock exchange rose by 60%. This resonated with Chinese. Most of them never being interested in investing now they decided that it is a chance for them to be next Buffet. 

First half of 2015 is obvious symptoms of speculative mania. Chinese discovered brokerage accounts and in March there was over 4 million new personal accounts. The true shocker happened in April. In just one week 4.4 million Chinese created their brokerage accounts to turn their hard-earned money into extremely overprices shares.

Source: zerohedge.com

We can clearly see the result of so called ‘dump money’ thrown in the shares market. Index of the biggest companies – CSI-300 – spiked by 60%, Chinext (equivalent of Nasdaq) flew up by 170%. Everything in 6 months.

Source: zerohedge.com

Finally in the mid-June markets in China reached their records. Averaged ratio P/E for Chinext blew over 60.

Recap: ratio above 20 translates into very expensive shares.

State of the madness was mimicked by results of IPOs. When new company tries to get capital it issues new shares. It has to find buyers so price must be reasonable. Last months demand for new shares was so big that the average increase of price in one moth after IPO was equal to 260%. Imagine: you buy shares during IPO for 100 CNY only to sell them for 360 CNY in just 30 days! That is return on investment!

Ratio of margin debt – debt taken to buy new shares – to capitalisation of the stock exchange reached record high 4,2% overshadowing even stock exchange in the US.

The bubble eventually bursted.

Next two weeks wide index of shares lost 22% and it is the most rapid fall in 15 years. The most ‘pumped’ index of tech companies Chinex lost over 32% and it is very much possible that it will not be the final number. Suddenly street investors saw that share prices do not need to move only in one direction.

In described crisis there is nothing strange. It is something perfectly normal that ‘smart money’ move from one market to another. The higher prices the lower potential for them to stay on climbing course when simultaneously the risk of correction or slump is growing really fast.

Global capital in those circumstances move to cheaper markets while local investors are left with overpriced shares in their portfolios.

Chinext situation very much resembles Nasdaq from 2000. Street investors who bought shares ‘when everyone was buying’ needed to wait till 2015 to nominally get back their money. Unfortunately purchasing parity of dollar today is way lower than dollar 15 years ago.

What happened on Chinese stock exchange in the last two weeks should be a small lesson and a warning for people who would want to come back to shares market and fetch back their wasted time. Global market is experiencing boom and it is the longest boom in 80 years. Cheap shares are very hard to find. Apart from Russian market and companies producing gold and silver nearly all shares are expensive. In my portfolio percent of shares are on the historical low. Recap: typical boom is 3-4 times longer than a slump. Therefore, drops magnify levels of hikes. Sometimes it is better to stand by for a month too long than few days too late.