The stock market II

When an investment market opens up, frenzy comes and the securities prices shoot through the roof. Such an intelligent man as Isaac Newton got his fingers burnt as a market bubble burst in his time. i believe the recent market excitement happening in China and Hong Kong stock markets would lead to disappointment for many investors. Optimists back today's high valuations of China-related stocks saying that the country's economy in its best shape justifies even higher valuations. But the linkage between economy and investment could be weaker than many people think. i agree that China is formidable going forward. Still, the market is likely to fall. An investor who bets on China's great future is investing for a good economic reason but at the wrong moment.

The mere opening of the access of something that looks classy invokes emotional crowds. Consider some daily observations. The opening of the first Hong Kong branches of Japanese stores -- Mos Burger and Uniqlo, and the opening of Hong Kong Disneyland brought many people who didn't want to lag behind. The opening of the Lowu border to individual tourists also drew unprecedented enthusiasm. The opening of an investment market has similar impact on investors' sentiment. The tulip mania in the Netherlands in the 17th century was a classic example.

Trading in tulips had become a business since a botanist succeeded in planting the Turkish flowers in Dutch soils in late 16th century. Elites collected luxurious tulips just like today's rich and powerful keep variegated carps. However, the phenomenal surge of tulip prices did not happen until stock exchanges listed tulip interest as securities and futures contracts, making trading of the flowers available to the public in the early 1630's. The tulip market collapsed in 1637.

China's world-class shares that used to be available for Hong Kong and international investors only are now open to mainland investors through "A-share" listing in mainland's exchanges. That has triggered speculative interest. Such interest also has its impact on the Hong Kong bourse.

Looking back, we might laugh at those tulip investors for their stupidity to invest in useless flowers. Tulip investors, or traders, did not mind buying expensive flowers as long as they believed that someone else would buy them at even higher prices in the future.

Today, investors who trade Chinese shares are no pure traders. They buy them for a good reason -- China's bright economic outlook. However, history shows us that a good reason fell short of justifying an investment. China's economic prospects are as good as, if not better than, Hong Kong's in the 1970's, when the city was under development. Still, the Hong Kong market took a spike and suffered a crash in 1973, leaving many investors broke. During that booming period preceding the crash, the big hit was a stock called Hong Kong Antenna. The share price ballooned 50 times on the debut day.

Hong Kong Antenna was a typical concept stock. The reason for buying Hong Kong Antenna was no less compelling than any investment ideas ever. In those years, television broadcast had just become popular. Just imagine every household would buy an antenna from that company. You would have brought the stock for that idea. True, for the years that followed, every household did have a television. The reason to buy was good. But it was later found that the household did not need private antenna because all households in a building could share a common antenna. The investment in Hong Kong Antenna was wrong.

We learnt from the lesson not to buy small companies. Buy the big ones. But the big ones can run into trouble just like the small ones. In 2000, Americans sought Yahoo -- a giant in the dot-com industry. Yahoo was young and revolutionary. Yet, the following industry development was unpredictable. Googles emerged to change the ecology. Today, Yahoo's share price has yet to go back to its 2000 peak.

Hong Kong's PCCW was a regional heavyweight under the leadership of Richard Li who had the ambition to turn every television into a computer. Now, seven years are gone and such television-computer convergence is in sight. However, the hope comes too late to rescue the share price of PCCW.

OK, we learnt another lesson. Let's rule out the technology concept companies. Apart from a good economic reason and a big company, investors should demand solid businesses.

Chinese insurance companies and banks fit these prerequisites. They are big and operate in a fast growing economy and they have solid businesses -- the kind of businesses acting as the cornerstones for advanced economies in the U.S.

However, the U.S. has had its own market crashes too. And the bigger losers were ironically the solid business runners. In the year proceeding 1929, the American economy was on the growing track with low inflation. Optimism lied on the utilities, gas and power companies, for their promising businesses under the favorable economic conditions. That optimism, leveraged by margin buying and heavy involvement of fund management companies, led to high valuations of those stocks. Towards October, share prices of those stocks had risen so much that their valuations had a price-to-earnings of over 30 times and price-to-book over three times, although the price-to-earnings for the overall market was at a comfortable level of 15 times. Doesn't that sound familiar?

There are many explanations about the historic crash, including wrong monetary policy and regulatory decisions. But the underlying force is clear -- valuation cannot defy gravitational force for long, however positive the economic conditions are. Leading economists Irving Fisher and John Keynes lost a lot of money in the 1929 crash.

Valuation reflects the expectation of returns. Sometimes, however, valuation goes far ahead of the economy. Traveling back to the Hong Kong in its 1972, we might well bet on the stock market reasoning that the Hong Kong economy would prosper in the following two decades. Your prediction about the economy would succeed. But still, your investment had to be wrong.

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