Dozens of explanations all basically claim the following:

China's stock market continued to boom despite the country's increasingly gloomy economic outlook, and this eventually created a bubble that popped.

The above sentence cannot be more vague. Although everyone claims it's true, no one seems to give an explanation why it is true.

Why is there a bubble? What is a bubble? Can someone explain in more depth how, a booming stock market accompanied with a slow growth economy, would create a crash?


2 Answers 2


Stock prices predominantly are a quantification of the company's future growth and profit prospects. These are expectations, and are partly based on how the specific company performs currently and has performed in the recent past, but also on what the "general economic outlook" looks like (expectations again): if it is "gloomy", we expect that this will constrain even the best of companies.

A usual "stock market bubble" is a situation where there is a unabated inflow of new investors (so new money, available to buy stocks, flows in the market), and where the general tendency of the prices of the stocks is to rise, and at a fast rate.

Experience has taught us that even in a sample of a few hundred companies, there is no way that the majority of them will excel in economic performance at the same time. So the "short-term general tendency of stock prices to rise" must come either from positive expectations on the "general economic outlook" (rather than the assessment of each individual company separately), or from a "Ponzi-scheme" climate, which is often the case at least in new stock markets in emerging economies: investors demand to buy stocks simply because they believe they will be able to quickly sell them at a higher price to somebody else, irrespective of what the "economic fundamentals" are, as regards actual economic performance. This fuels stock prices which in turn represent a signal to outsiders that indeed, they too can come in and play this game.

The thing with Expectations is that they may have no inertia: they can swing abruptly. So if in the middle of such a rising-stock-prices trend (which already may not be based on the actual economic performance, as said), comes a change of Expectations for the gloomier, suddenly investors "see" that the prices are over-inflated. The inflow of willing investors to buy at even higher prices suddenly stops, and those with the papers in their hands (but not with the money) start to accept lower and lower prices in order to reduce the damage. And this too happens fast. And this is when "the bubble bursts".


Robert J. Shiller defines a speculative bubble in Irrational Exuberance as:

"Irrational exuberance is a psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of a price spurs investors enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase and bring in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others successes and partly through a gambler's excitement"

He gives a few cultural reasons for this, but since his book is based on the US I would take it with a grain of salt. They are the advancement of capitalism (he includes China here), the increase emphasis on business success, the revolution of information technology, the demographics of the baby boom, the decline of inflation and the money illusion, and the rise of gambling and pleasure in risk taking in general.

I will be focusing on what he says operate on the foreground, which are greatly increased media coverage, the aggressively optimistic forecast of stock analysts, the rise of 401(k) plans, the mutual funds explosion, and the expanding volume of trade in the market.

"The real reason" is such a large amount of factors that it probably will never be known fully.

I cannot stress enough on how I have no idea on Chinese culture. I have no idea what their media says, what the individual China man thinks about inflation or market movements, what Chinese forecast models look like, or if China has been experiencing a rise in middle class gambling (although lately I have been making a killing shorting WYNN casinos, that's a whole other story).

I do know a few things however. China does sort of fit the baby boom theory, because of the one child policy. They artificially have created an aging population.

They also do fit the rise of 401(k). Now I have no idea if the employer matches benefits of employees (my guess would be no), but I do know that China's emerging middle class has very little options when it comes to investments and savings. The first major investment choice is real estate, then not to long ago they where allowed to enter the financial markets.

So, with that said, we can examine what happened. While much of China's GDP is exports, a large part is also construction. The last 30 years has been unreal. Whole cities have been built all over the East coast. Watch this 60 minute report. The dramatic slowdown in building hit the economy and effected the GDP, but more importantly for this discussion the Chinese investor lost his best investment vehicle. Many investors started to look at the market. As more investors jumped in, stock prices rose, returns rose, investors became irrationally exuberant, invested more, stock prices rose more, returns rose more, more investors became irrationally exuberant, so on and so on.

You should look at this graph. For professional investors, it is startling. You do not need a PhD to realize that this a bubble. Investors started to hedge their positions, and once the herd spooked, the bottom fell.

This is a over simplification. You should also read how China has opened up their markets over the past decade. People can come up with technical details of why, but it is almost irrelevant. When you have companies valued at millions of dollars that haven't made one sale, something is going to happen.

China's actions aren't helping either. The Chinese government has been claiming to open up the markets, but they are regressing back to their old ways. Putting out inaccurate data, placing short sellers in jail, devaluing their currency over 2% in a day; these actions are not inspiring confidence.

A common misconception on bubble's is that they start because of economic slow down. This is not required though. A bubble is when the financial markets no longer reflect the real market; and eventually that bubble gets corrected.

All that being said, a buying opportunity is when everyone is selling. Crashes happen fast and swift, gains are long and slow.

I leave you with one more quote from Robert Shiller, a book I definitely recommend you read if you want to know more.

But it was never my intent to argue that one can explain the ups and downs of the markets well in terms of the precipitating factors alone. The markets have lives of their own due to the effects of feedback, the amplification mechanism that spreads out the effect of the precipitating factors through time and that sometimes makes the effects of the factors so big and so important as to take our breath away.


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