China Market Cap to GDP at 118% and Margin Debt at 3.6%, after 130% Stock Market Yearly Rise. What Follows?

The financial mania continues after several ZIRP years. The low interest rates, G7 as well as Chinese liquidity injections have created a marketplace prone to more speculation and financial engineering. During the last quarter, the stock markets in China have been setting new records. In just a year, the Shanghai Composite Index (SHA:000001) increased by 130%, a seven-year high, and a 300% increase has been registered by the Shenzhen ChiNext market, which focuses on small-cap companies.

China Stock Market Cap to GDP Is Giving a Warning at 118%

The hysteria in the Chinese stock markets have led to the launch of an uncontrollable number of private equity funds, and hedge funds, actually the Financial Times, in an articles published on June the 14th it was revealed that over 4000 new hedge funds were created in China during in less than three months. We at Octafinance wonder is this another sign of a bubble? When looking at the price chart of Chinese stocks and as reported by Bloomberg that the Chinese stock market value reached $10 trillion or an increase of $6.7 trillion in just one year, we wonder is the Buffet’s favorite indicator of GDP-to-Market-Cap flashing a warning?

“Over the last 12 months, Chinese listed stocks have experienced an increase in market cap of $6.435 trillion – the largest twelve month increase for any country’s market cap in history. The previous record twelve month market cap increase of $5.811 trillion was set by US stocks during the twelve months ending March 2010, after US stocks bottomed in March 2009 during the global financial crisis.” NIA reported.

Currently Buffet’s favorite stock bubble (Market Cap to GDP) indicator for China is at 118%. It’s in the warning zone (110%-130%) but probably not at super bubble territory (150%+). We at Octafinance, believe that the Chinese’s bull market could turn into secular bull market and reach even higher levels but not without a correction. And with all the warning signs here, we might be near one.

Chinese Financial Market Development in Action

The private investment funds, also including venture capital and private equity, have seen their quantity really increase during the past months in China. As of the 1st of June, according to data obtained from the Chinese securities regulator, the quantity of funds reached 12, 285 compared to just 7,989 three months ago. This is an increase of 4000+ funds. Also noted was a six fold increase of assets under management, increasing to $433 billion, which is an increase of $75 billion.

The chairman of WinSure Capital, Feng Gang, remarked that it was an attempt of the government to encourage entrepreneurship in the financial sector. Having spent 14 years working in the financial sector, with the latest occupation being at China International Fund Management, a Joint venture with JPMorgan Chase & Co., Feng established his fund just four months ago.

“For 14 years I have never notices such supportive changes. We are top runner, in the investment sector,” Gang noted

Just over a year ago, the government in China made changes to the registration process of hedge funds and private equity which became less complicated for which there has been an increase in new funds applications.

In only three months, the number of PE funds and hedge funds employees also increased by 60,000 to reach a number of 200,000 employees at the beginning of the current month. It should be noted that, compared with US hedge funds, the Chinese ones are a lot less. From the 12k+ Chinese funds just 56 manage more than $1.6 billion (10 billion RMB) in assets.

Chinese Margin Debt In Parabola Same As the US One

Stock analysts and forecasters also point to another warning sign, the skyrocketing Chinese margin debt. The country reached a record of $358 billion margin debt or 3.6% of the country’s stock market cap. For comparison, US margin debt as reported by nyxdata.com hit $507 billion in April or 2.3% of the $22 trillion stock market cap of all US stocks. As shown on the chart below, margin debt is connected with every bubble high and crash in the stock margin history. We doubt this time will be different.

Margin debt is getting more important as the self supporting cycle of more debt and higher prices and more debt is starting to worry the Chinese regulator. They want to slow down the debt increase without triggering and causing panic and crash. Of course, we doubt that’s possible as in the previous cycles of debt manias support stock bubbles in the USA, we remember that once the margin debt stops its parabolic up-move, the only direction is down and never flat or range one.

The Shanghai Composite Index lost more than 7% on January 19 when the Chinese regulator forbid new margin accounts at some of the biggest Chinese brokerage firms. Despite the debt climb back in few days, we feel the next time could bring a more serious correction or even stop completely the Chinese bull market (not likely in our view). Hao Hong, an analyst at the Bocom International Holdings Co. based in Hong Kong commented that if illegal margin lending activity stops and the accounts are closed, the stock market will crash for sure.