The Shanghai Composite Index was trading at 4,123.923 as of July 23, 2015. The 52-week range is an incredible 2,072.23 – 5,178.19 and the one-year return is 102.12%. Where does the Shanghai Composite Index go from here?

Defying Logic

Let me first begin by disclosing that I own shares in exchange-traded fund (ETF) Direxion Daily FTSE China Bear 3X (YANG). I don’t usually favor leveraged ETFs, but you will understand why I’m long on YANG soon. (For more, see: Leveraged ETFs: Too Risky for Their Own Good?)

Let’s begin with the most basic math. For the second quarter, China’s gross domestic product (GDP) grew at a 7% clip, which was better than the expectation of 6.9%. However, this is still the slowest growth China has seen in 20 years and it’s highly doubtful that the 7% reported number is legit (China lacks regulation).

The Shanghai Composite Index recently dipped below 3,600. In order to stop the bleeding – and to keep the party going – the Chinese government stepped in and changed the rules. These rules included:

1. Not allowing major investors and pension funds to sell for six months.

2. Announcing that short sellers could be arrested.

3. Creating a $486 billion fund to buy stocks.

4. Suspending stock trading on Sept. 3 and 4, claiming this to be in order to commemorate the Japanese surrender in WWII. This has never happened before. The secondary reason given for suspended trading was "liquidation matters" to be undertaken by the China Securities Depository and Clearing Corporation Limited (CSDC). (For more, see: How China's GDP Is Calculated.)

5. No initial public offerings (IPOs) since early July.

6. Hundreds of companies being allowed to suspend trading (to ride out volatility).

The Chinese government is worried because if stocks plunge, then bank balance sheets will be torn apart, which is what usually leads to a bubble popping. Changing the rules to the game has led to a bounce in Chinese stocks, but it’s not sustainable. (For more, see: Greece or China: Which is the Bigger Worry?)

Factors Contributing To Bubble

The biggest contributors to this equity bubble – the largest equity bubble throughout history – are low interest rates, an IPO boom, and excessive leverage. The latter is especially important. There are no margin regulations in China, which has led to astronomical gains in equities. But here’s where it gets interesting. According to The Wall Street Journal, 97% of growth in manufacturing companies has come from stock gains. Manufacturing companies have stopped manufacturing because they’re making more money in the stock market. So what happens to these manufacturing companies when the stock market heads in the other direction?

To give you an idea of how insane the equity market is in China, Chinese stocks recently set a record for the shortest average holding time in history: one week. Do you remember the Taiwanese stock market bubble in 1989? The average holding time was two weeks, and stocks eventually plunged 80% over a period of eight months. Now consider that China’s bubble is even worse.  The real economy in China is slowing. Even if a company is failing, the Chinese government is insisting that banks still lend to those failing companies. How will those debts be repaid? What will the end game be for those banks? (For more, see: Caution: Is This Massive Chinese Bubble About to Burst?)

End Game

The Chinese government is doing everything it can to keep its equity (and real estate) market afloat, which includes rhetoric in state-run papers. However, all the Chinese government is doing is buying a finite amount of time and fooling itself that it can artificially move its economy in the right direction by using force. The only real solution is to allow the economy to deflate, deleverage, deal with the pain for many years, and get back on track in a responsible manner. But with central banks playing such big roles around the world, that isn’t a possibly in this era.

This is unfortunate. If you look at the U.S. stock market crash of 1929, it led to the Great Depression, but debts were eventually paid off, and it also led to the greatest economic boom in history. The Japanese, on the other hand, attempted to continuously throw money at its economy after the 1989 crash, and the economy has gone nowhere ever since. The Chinese are taking the latter approach. As far as going long somewhere if Chinese stocks crash, which will lead to contagion, you might want to look into U.S. Treasuries and the U.S. dollar. (For more, see: The Reasons Why China Buys U.S. Treasury Bonds.)

The Bottom Line

In my opinion, the current bubble in Chinese equities puts the dotcom bubble in the U.S. to shame. It’s also worse than our 1929 stock market bubble, the Japanese stock and real estate bubble, as well as the Taiwanese stock market bubble of 1989. I think it’s actually conservative to project that the Shanghai Composite Index will be at 2,000 (possibly much lower) by this time next year. It might take several months for this bubble to pop due to Chinese government tactics, but it’s impossible to fight reality. (For more, see: 5 Steps of a Bubble.)

Dan Moskowitz is long on YANG. 

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