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Where are Shanghai stocks on the scale of pessimism to euphoria?

Attendees gather for an investment seminar held in Shanghai. (Photo by Itsuo Toshima)

Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.

-John Marks Templeton

     The late American-born British stock investor seems to have uttered those words sometime in the 1990s. We revisit them today amid growing skepticism that Chinese equity markets have reached bubble status. We revisit them as Chinese retail investors, it seems, remain plenty optimistic that Shanghai stocks still have upside left.

     Or are China's newbie investors in a state of euphoria? If they are, could that group dynamic change to panic when the market, as markets tend to do, goes through a correction phase?

     Think of a packed theater. Now think of everyone in the audience getting up at once and running for the exit.

     One point to keep in mind here is that most Chinese investors cannot satisfy their strong appetite for stocks by buying foreign shares. With a lot of Chinese investment money flowing through one narrow channel, and with everyone looking for high-yield wealth management products or stocks, speculation can easily set in.

Market savior?

Chinese authorities are mindful of this potentiality, so they spar with the market, talk it down, keep it from overheating, even tighten regulations on margin trading.

     If the Shanghai boom is a classic stock rally, cooling market sentiment will also help to rein in sentiment.

     That said, Shanghai share prices have been on a phenomenal bull run since the beginning of the year and are attracting many individuals who have never before played on a stock market. Yippee ki yay!

     Or maybe not. At this stage, something as seemingly benign as introducing unexpected regulations could burst the balloon. The resulting negative wealth effect could dent consumer spending. This is exactly what the current administration is trying to prevent. In fact, the government is trying to gin up some domestic demand-led economic growth.

     But about those unexpected regulations: It must be said that Shanghai stocks have reached a stratosphere that even puts them out of reach of President Xi Jinping himself, were he to want to talk them down or lasso them with a new regulation.

     The market is gaining momentum all on its own, and if this sounds like they are off on a euphoric high, well, then, perhaps it might be best to remember Templeton's quote.

     Yes, the Chinese economy is facing an emerging risk factor.

     A sharp setback on the stock market could also highlight the risks of wealth management products, which have been obscured by the hustle and bustle of the stock market. Investors will have to pay careful attention.

The band plays on

Estimates vary, but the market for WMPs that feed into China's so-called shadow banking system is likely worth more than 10 trillion yuan ($1.61 trillion), though WMPs with default risks appear to account for less than 10% of the total. Nevertheless, the stock market rookies might not have the savvy to avoid losses and ward off paranoia were Shanghai stocks to face a crisis. A default somewhere in the land of WMPs could convince them to shoot from the hip.

     Many investors holding WMPs are under the influence of a moral hazard, believing the government will protect them from any default. But the government is expected to let a "selective default" go through by the end of the year to increase risk awareness among retail investors.

     But what good would such a teaching point be when a lot of the newbie investors don't even have "default" in their vocabularies? What good would it be when sales of WMPs peaked in 2011 and 2012, with banks selling the instruments without explaining the risks involved and without complying with regulations?

     Were Shanghai stocks to decline precipitously and reignite WMP worries, systemic risks could set in.

     What is more, China's negative wealth effect has already become obvious -- it can be seen in declining property prices.

     Chinese authorities do have some tools at their disposal should they want to keep a floor under Shanghai stocks. They could encourage the country's major pension funds to buy shares. In Japan, the government is doing something similar.

     But unlike in Japan, Shanghai's key market players are small-lot investors. It is not known how they might react to Big Brother stepping into their playground. The situation is so fluid, even big New York-based hedge funds are wary of mainland Chinese shares.

     Risks are gradually developing. That much is known. Where they go from here is not known. They could even be affected by a U.S. interest rate hike and/or Greece's debt problem.

Itsuo Toshima is an independent investment adviser based in Tokyo and a former Japan representative of the World Gold Council.

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