oftwominds-Charles Hugh Smith

Shanghai Stock Market: the Top Is Near

When cookie companies are launching leveraged funds to invest in the Shanghai Composite Index, you know the top is in. I refer of course to Kroika Cookie Company's new "Cookie Dough Fund."

As noted previously here (see the book Fiasco: The Inside Story of a Wall Street Trader for more), many corporations trade derivatives despite the fact such hedging has nothing to do with their core business. (I mean derivatives traded for speculation, not currency hedging of overseas sales, which is of course simply prudent money management).

But Kroika is stretching the envelope in launching an investment fund open to the public. There is even talk in Xiangxi HQ about pitching the fund on every package of cookies, along with a slogan such as "Let your fortunes rise like warm cookie dough!" (My suggestion.)

Long-time readers know Kroika is a "secret" sponsor of this site, paying me big bucks to mention their products in an "authentic" fashion, such as: if you're going to buy a high-fat, high-sugar, high-salt hydrogenated-oil death-bomb anyway, then by all means indulge in a package of Kroika! cookies. (Bing! One grand! I love this sponsorship!)

Kroika was last hyped (oops, I mean mentioned) here for its signature high-rise building, the world's tallest bamboo structure, which is currently under construction in the suburbs of Shanghai.

Kroika's prospectus did give me pause. Buried in the legal mumbo-jumbo and caveats is the sobering disclosure that the fund intends on investing only in highly leveraged derivatives on the Shanghai Composite Index, which as the chart below indicates, has been on a Nasdaq-bubblelike tear since mid-2005: I have indicated the Fibonacci numbers of its current climb to the stars; having blown past previous levels, it is now approaching a fibo just below the 4,000 mark. If the Index reaches that close, it may well push over 4,000, as these round-number levels act as attractors.

How sustainable is such a rise? One place to start an analysis is to look at the previous big run-up, which rose 1,729 points over 5.5 years. The current run has added 2,843 points to the index in less than 2 years. Does this look a tad frothy to you?

It looks normal to the intrepid fund managers Kroika has hired. They're undoubtedly bright, but should 19-year olds be playing with millions? The lead manager is a 19-year old economics studen with a hot hand trading the Shanghai Composite; he apparently traded next semester's tuition of $430 U.S. into $100,000 in the past few months, using out-of-the-money calls and maximizing margin debt. His compatriots are a 22-year old female banker who quit a safe but low-paying government gig to parlay her mother's hocked gold jewelry into $200,000 last year, and a junior analyst who has not yet graduated from high school. The math whiz turned his wages from a weekend job at Kentucky Fried Chicken into $300,000 over the past two years. After a few missteps with the Scholes calcs back when he started at 16, he's generated huge profits by leveraging leverage. (Don't ask.)

Lest you think this is mere farfetched parody, consider these recent articles: from the Wall Street Journal (subscription required, or check it out at the library): As Funds Leverage Up, Fears of Reckoning Rise:
"Hedge-fund manager John Paulson made $1 billion using a complex financial instrument to pump up a bet that the subprime-mortgage market would crater. The parent company of retail giant Sears made $74 million using a similar device to boost its wager that a basket of stocks would rise in value. Both were playing with leverage -- the magical power that allows investors to make big investments without putting big money on the table.

These days, they have lots of company. Thanks to advances in financial engineering, investors have never had so many different ways to make commitments that exceed their bankrolls. And never before has leverage wormed its way into so many nooks of the financial world. We're living on planet leverage, and regulators and market gurus are growing nervous."

And this from The Economist: The People's Republic in the Grip of Popular Capitalism; Tens of millions of Chinese are risking their shirts in a stock market frenzy. If it goes wrong, things could get nasty.
"WOULD-BE share punters, keen for a piece of China's booming stock market, are queuing to open accounts at a Beijing branch of China Merchants Securities. A busy manager, handing out application forms, says he is taking on 100 new clients a day, perhaps five times as many as a year ago. Bunches of small investors, ranging from students to pensioners, crowd around computer terminals to carry out their trades, keeping an eye on the prices as they flicker across big electronic screens. China's biggest-ever stock market boom may be turning into a bubble—and the country's leaders are getting worried. If the bubble were to pop, it could have a bigger impact on social stability than any previous downturn in the stock market's 16-year history.
There are now more than 91 million accounts held by individuals at brokers or in mutual funds."

How much longer can such a mania last? The short answer is, "Until the last yuan of borrowed money has been invested." The other short answer is: a matter of days, a few weeks at most. Some perturbation (rising yen? U.S. market decline? Meltdown of the Turkish exchange? Fill in the blank) will upset the expectations of the leveraged punters, and a sell-off will strike with frightening fury.

As the financial carnage sweeps across the globe, an investment in plain old cookie dough will start looking absolutely brilliant.

To view the chart, go to www.oftwominds.com/blog.html