Bubble-ized Survival After Total Market Capitalization Exceeds GDP

Author: [Mu Zi]
Source: [Fund Analysis]
Article type: Regular article
Published: 2007-8-18 15:23:13
Column: Expert Perspectives

In the inaugural issue on March 19, this column's first article, "The Divine Continent Has Its Midday Sun — Ten Thousand Nations in Court Robes Dance at the Nine Shao Ceremony," provided a basic judgment for this great bull market: at least 20 more years with a 30,000-point rise. This view remains valid with nothing to revise. In the same article, the basic characteristics of the first phase of this rally were also laid out. I quote: "The first phase of the rally accompanies the institutional and structural perfection of China's stock market itself. After this, China's stock market will truly possess the qualifications to participate in the global feast. Full circulation, whole-company listings, functional restructuring of the two exchanges, the gradual convertibility of the RMB, and so on are all inevitable steps of this institutional and structural perfection. In this phase, the rally primarily manifests in constituent stocks represented by heavyweight stocks. It is laughable to talk about stock market bubbles before total market capitalization exceeds GDP. Before China's stock market capitalization exceeds its GDP, the first phase of the rally will not end."

Clearly, the judgment that "before China's stock market capitalization exceeds its GDP, the first phase of the rally will not end" has been proven by today's facts, because China's total stock market capitalization has already exceeded GDP, yet the first round of the constituent stock rally continues. If there are still questions about what constitutes the first-phase constituent stock rally, then the recent spectacle of elephants dancing wildly in the Chinese stock market should provide the best illustration.

At this historic moment when market cap exceeding GDP has arrived on schedule, we must define the nature of the rally going forward. After market cap exceeds GDP, China's capital market will enter the bubble-ization phase of the first-phase constituent stock rally. Participants in China's capital market will enter a state of bubble-ized survival after total market cap exceeds GDP.

As stated in the quote above, "it is laughable to talk about stock market bubbles before total market capitalization exceeds GDP." But after total market cap exceeds GDP, discussing bubbles becomes very necessary. If we treat GDP as the center of gravity around which total market cap oscillates, then below it, the market can be said to be structurally undervalued, while above it represents a structural bubble.

Obviously, GDP changes. With China's rapid economic growth, the center of gravity for total market cap will continuously shift upward. Today's bubble may be tomorrow's undervaluation — all of this must be viewed dynamically. A structural bubble does not mean the market has no reason to rise. Rather, it means that the foundation of such a rise carries the gravitational pull back to the center, and once the short-to-medium-term reasons for rising are insufficient to resist this pull — regardless of whether the rise pushes total market cap 30% or 300% above GDP — the eventual pull-back will produce a correction of corresponding magnitude.

If the area around 4500 corresponds to the fairly certain current GDP center, then China's rapid economic development will in 20 years push GDP to at least the current U.S. level — that is, a GDP of 100 trillion RMB would be perfectly normal. The corresponding center for the capital market would shift up to around 23,000 points. At that time, short-to-medium-term oscillations pushing the index to 30,000 or even 50,000 would all be imaginable. Markets always oscillate. The market can oscillate around the center, but it absolutely cannot be ruled out that oscillations will drastically overshoot the center — only such overshoots inevitably lead to corrective pull-backs.

Setting aside long-term targets, returning to the bubble-ized survival state of the first phase: the only thing that can resist bubbles on a long-term basis is the upward shift of the center brought by growth. Once growth is insufficient to support this center's upward shift, large-scale bubble bursting is perfectly natural. Moreover, such bubble bursting often causes short-to-medium-term movement to fall below the center, creating a new undervaluation — which in turn constitutes an excellent medium-to-long-term entry opportunity.

The reason the current bubble-ized survival of China's capital market does not yet constitute massive pressure is that even the largest constituent stocks, viewed in the historical development of world capital markets, still qualify as high-growth stocks. As long as this status persists, a moderate bubble-ized survival is reasonable and natural.

However, market rallies always begin in irrationality and end in irrationality. Without frenzied undervaluation, there would be no frenzied bull market. Similarly, without frenzied bubbles, there would be no frenzied bear market to create new historic undervaluation entry points. The first-phase constituent stock rally must inevitably end in frenzied bubbles. During the process of creating frenzied bubbles, one can actually harvest enormous profits. If undervaluation returning to the center can produce 10x stock returns, frenzied bubbles can have even greater power. For any market participant, patiently waiting for the market's frenzy, and within that frenzy waiting for the final selling point, is the most important and most worthy skill to cultivate.

Clearly, the market's most frenzied state has not yet appeared. External factors creating short-term oscillations actually benefit the market's energy accumulation. Before bubble-generating capacity is fully unleashed, the market will not ultimately reverse, and the first-phase constituent stock rally will not end. Stop strategically buying. Only strategically hold. Wait for the market's frenzy. Wait for the first-phase long-term selling point to appear. This is the most appropriate strategy under the bubble-ized state.

(Special Senior Advisor to this publication, Mu Zi)