Over the next couple of months, China’s stock market could crash another 50%.
It won’t happen overnight. But as I’m about to show you, the bull market in Chinese equities is over. And before the crash is over, investors could lose 20%, 35%, 50%, or even more.
Let me explain.
As the great Yogi Berra once said, “If people don’t want to come out to the ball park, nobody’s gonna stop ‘em.”
That’s the Chinese stock market right now. People want to sell. No logic, no matter how articulate, is going to calm them. And for investors who fail to heed the warning of crowd psychology, it will be like getting run over by a freight train.
The bubble in the Dow Jones Shenzhen Index has popped. After rallying over 180% over the course of 13 months, the index has shed nearly half of its value in just a few months.
Chinese authorities are doing their best to re-inflate the bubble by buying shares, outlawing short sales, and restricting new public offerings. The Shenzhen Indexresponded by rallying over 200 points, but this measure is only temporary. As soon as the government withdraws their support, equity prices are likely to resume their downward slide.
How far could Chinese shares plunge? We can look to the charts for clues.
Charts courtesy of www.StockCharts.com
Chinese stocks are exhibiting a classic bump-and-run pattern, a common formation that occurs during a market bubble.
The “lead-in” phase part is the first phase of the pattern. During this period, prices advance in an orderly manner. There’s no excessive speculation as investors bid up shares in response to growing earnings and improving fundamentals.
Next comes the “bump phase.” During this period, retail and other “dumb money” investors start to pour in. Prices advance rapidly with little concern for profits or the health of the underlying business. This phase is comparable to the height of the Dotcom mania of the late 1990s. In China, this was when we started hearing stories of high school students becoming millionaires trading penny stocks and farmers giving up their jobs to invest in equities.
Finally comes the “run” of the bust. Without a steady stream of new investors to push up prices, markets hit a top. Because indices are so far away from the underlying fundamentals, any selling can explode into a full-out panic. Prices may find support at the lead-in trend line, as Chinese equities have done in the chart above. But eventually, the market needs to correct further in order to wash out all of the speculators.
How much further could prices fall? When bubbles pop, it’s not uncommon for prices to overshoot to the downside. In many cases, prices fall all the way to the beginning of the lead-in phase.
In the case of the Shenzhen Stock Exchange, that means the index might not find support until the 300 level. If so, Chinese equity prices could crash another 40% or 50%.