Lessons from China ... Individuals Borrowing to Buy Stocks ...The Binge Is Over ... Buying on Credit Should Always Be Minimized and Avoided When Possible

People have a habit of borrowing in excess to buy many 'things,' believing that the 'things' they buy will appreciate in price and big profits will follow shortly. Of course, that's exactly what happened to many American home buyers and buyers of internet stocks in the early 2000's.

But excessive borrowing is not a habit unique to American home and stock buyers. Human nature is human nature and bubbles are bubbles, regardless of where we live.

In fact, many individual Chinese stock buyers have been blowing their own bubbles recently. Alas, the Chinese market is falling rapidly now as the bubble in stock prices apparently has burst. See China Markets Fall Sharply Despite Fresh Help From Beijing.

Owning our own home can be great and owning stocks for the long haul can be great as well. The key word is owning and being relatively debt free. And that's because huge debts incurred to purchase otherwise unaffordable 'things' can be dangerous to our financial health. Excessive borrowing to acquire 'stuff' is neither a good investment philosophy nor approach. It's speculative and that's just another word for gambling.

And when we make major purchases on credit, it's not just the periodic interest payment that matters. The ability to repay the principal is even more important than the monthly payment obligations. And that's especially the case when the value of the asset is less than the loan amount outstanding, aka the 'underwater' asset.

Our inflationary economy of the past several decades has encouraged a 'buy it with as much borrowed money as possible before the price goes up and then sell it and pocket the profits' mentality and practice. But when inflation is halted and prices don't rise, the game changes for debtors. And so it has come to pass.

The message is simple and straightforward. When 'renting' an asset, we pay for the rental period and then again when the debt is extinguished. But sometimes, in fact usually, the asset doesn't appreciate in price. Then we learn that the good deal was a bad deal, but by then it's too late.

Chinese Investors Who Borrowed Are Hit Hard by Market Turn has this sad story to tell:

"SHANGHAI — With his stock market riches, Gong Yifeng bought a riverfront apartment here for his son and daughter-in-law. He can eat well and travel abroad. He can also afford to pay for his granddaughter’s education.

But the losses are rapidly piling up for Mr. Gong, a retired shipyard worker. With China’s stock market 30 percent off its highs, his portfolio is down more than $30,000 in the last few weeks. “I don’t need a high-flying market, just a stable one,” Mr. Gong said.

Millions of ordinary investors like Mr. Gong, who piled into an ever-soaring Chinese stock market over the last year, are bracing for a roller-coaster ride. . . .

The situation is putting ordinary investors, many of whom invested in smaller stocks, in a difficult place. This latest slump may be just another periodic price dip. Or it could be the beginning of a lengthy downturn, like the one that started in late 2007, when the market eventually fell about 70 percent.

For now, Mr. Gong, 65, is sticking with stocks. . . .

What happened in China over the last year looks like another episode of the madness of crowds, when many investors seem to lose their senses. They started to borrow money on margin to buy shares they couldn’t afford. They bet everything on the belief that this was a new era, gleefully believing stocks moved in only one direction.

But there is a major difference between the markets in China and those in the other big economies like the United States. In China, mom-and-pop investors, rather than big institutions, make up the bulk of stock purchases. Such smaller players don’t necessarily have the resources to withstand the volatility.

 

The stock market boom began to take shape a year ago.

As property prices slumped, the government started to cut interest rates in an effort to stabilize the economy. With share prices looking undervalued and real estate in a rut, money flowed into stocks, said Chang Chun, a finance expert and executive dean at the Shanghai Advanced Institute of Finance at Shanghai Jiao Tong University.

The government further fueled interest by viewing the market as a way to help start-ups and innovative companies. The state-run news media began publishing articles about the coming bull run and the creation of exchanges geared toward listing new companies.

As droves of investors jumped on board, the stock market boom began to head into bubble territory. The nation’s two major exchanges, the Shanghai and Shenzhen stock markets, doubled and even tripled in 12 months. . . . Stock valuations in China hit the roof; some companies were trading at 300 times trailing earnings.

 

“Things got crazy, it really became a feeding frenzy,” Mr. Chang said. “People were talking about new economy stocks.” In the ChiNext market in Shenzhen, some academics found the average price-to-earnings ratio was about 140, even higher than the Nasdaq bubble in the United States in 2000, he added.

 

The market started to soften a few months ago. Worried about excess speculation, the government started putting restrictions on the so-called leverage, or borrowing, used to buy stocks. . . .

Heavy selling led to more selling. Since May, China’s stock market — the second-largest in the world after the United States — has lost nearly $3 trillion in market value. . . .

China is facing the stock market slump at a complicated time. The economy has weakened considerably, now that the country is growing at its slowest pace in more than a decade. Many local governments are heavily indebted.

With the stock market falling so swiftly, concerns have grown about social and political repercussions. The enormous amount of borrowing that helped lift share prices could turn into bad debt, hurting banks, brokerages and other financial institutions. And small investors could be devastated. . . .

The most vulnerable in a sharp, prolonged stock downturn could be people like Mr. Gong, the retired shipyard worker."

Summing Up

Not so long ago, too many Americans speculated with lots of borrowed money, aka 'invested,' in houses and high flying internet stocks, creating a bubble. In China today it's stocks.

But when these speculation based 'investments' are financed almost entirely by borrowed money, bad things happen to good people.

The bubble creating or asset inflating formula is actually a very simple one.

More borrowed money is the source for more demand, which in turn results in both higher prices and additional buyers to buy those newly higher priced assets.

This then leads to more borrowed money, more buyers and higher prices. And so on.

Until it doesn't. Then the bubble bursts, prices fall, debt burdens become unsustainable and debts go unpaid. Then prices keep falling.

Sound familiar? It should.

Today the U.S. stock market isn't in bubble territory. China's is, however, and China's Stock Plunge Is Scarier Than Greece explains why that's the case.

That's my take.

Thanks. Bob.