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Warning: Beware China’s Stock Market Surge

china-stock-marketLast Friday, I got a text message from my brother. It said:

“Chinese stock market is going crazy right now. People are taking out 2nd mortgages on their apartments and taking on credit card debt to invest. Things might get really unstable soon…”

My brother lived in Chengdu, China for more than five years. He married a Chinese woman, and they now live in New England. But with friends and family still living in China, he has a good grasp of what’s happening across the Pacific.

China’s stock market is in the midst of an incredible bull run. Over the last year, the Shanghai Composite Index is up an astounding 119%. That compares with a very modest 12% gain for the S&P 500.

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China Stocks Soar 119%

Shanghai-Composite-Index-chart

Source: Yahoo Finance

With stock prices rising, many Chinese people are piling into the market for the very first time. In many ways, it reminds me of the late 1990s Internet stock bubble here in the U.S. Everyone wanted to invest in Internet stocks, and everyone made money … until it all came crashing down.

So what’s fueling the rise for Chinese stocks?

There is strong evidence to suggest that the downturn in real estate is one reason. For years, real estate prices in China have been soaring. But within the last year, prices have stagnated due to oversupply. With real estate prices starting to fall, Chinese people are looking for new investments.

With stock prices roaring higher, investors have been borrowing money from their home equity or credit cards. And they’re using those funds to buy stocks. In just 16 months, margin balances at brokerage firms have increased fourfold.

New investors are likely fueling the rise in stock prices. Chinese people are opening up to 4.1 million new brokerage accounts per week. Just one year ago, that number was 70,000. That means there is a flood of new investors opening accounts and buying stocks.

There is evidence that these new investors aren’t exactly sophisticated. In fact, 67% of Chinese people opening a new brokerage account haven’t even graduated from high school. Shockingly, nearly 6% of the new investors are illiterate.

When you have lots of inexperienced investors piling into the market, it’s usually a sign of a bubble. And that’s exactly what’s happening today.

Not surprisingly, the rapid rise in Chinese stock prices has been sending valuations to the moon. Chinese small-cap stocks are trading at an average trailing P/E multiple of 90. According to a report from BNP Paribras, among all mainland China-listed stocks, 70% trade at more than 50 times earnings.

Just as concerning is that China’s stock market is soaring, even though the country’s economy is slowing. Just five years ago, China’s gross domestic product growth was around 12%. Today it’s just 7%.

If you’ve invested in Chinese stocks, you probably have exposure through a mutual fund or ETF. The iShares China Large-Cap ETF (NYSEArca: FXI) is the biggest, with $7.4 billion of assets. It’s up 38% over the last year. Small-cap Chinese stocks have done even better, with the Guggenheim China Small Cap ETF (NYSEArca: HAO) rising 41%.

Some individual Chinese stocks have posted far bigger gains…and many of these companies don’t have the financial fundamentals to back up those big moves. If you own any high flying China stocks, now is the time to lock in profits.

There remain some values in China, and that’s where I’m focusing my research. I know that sticking to the fundamentals – and finding value – is the best way to build wealth over the long run.

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