Stocks were mixed in early afternoon trading Tuesday, with the Dow Jones Industrial Average (DJINDICES:^DJI) and the broader S&P 500 (SNPINDEX:^GSPC) up 0.12% and 0.13%, respectively, just before 12:10 p.m. EDT. The Nasdaq, meanwhile, was down 0.26% Looking beyond these shores, index provider MSCI will today announce whether it will add domestic Chinese equities -- so-called 'A' shares -- to its widely followed emerging markets index. As such, it's a good opportunity to highlight the current euphoria sweeping over the Chinese stock market and the limits of index investing. If you own a Chinese stock bought on a U.S. exchange, such as Alibaba (NYSE:BABA), this concerns you, too!
Should MSCI add 'A' shares to its MSCI Emerging Markets Index, Chinese stocks could get a lift tomorrow and in the weeks and months to come. At present, only Chinese shares traded in Hong Kong are part of the index, and $1.7 trillion in investment funds are benchmarked against the index.
Index-tracking funds would need to buy shares immediately in order to match the 1% target weighting for 'A' shares in the index; this would drive $5 billion into this market, according to an HSBC estimate cited by Barron's. Add in buying from actively managed funds with the MSCI index as their benchmark, and a preliminary estimate pegs the total inflow at $20 billion, or roughly 1% of the daily trading volume in Shanghai.
The trouble is that this is the worst possible time to be jumping into Chinese shares with abandon -- there are more than enough willing retail Chinese investors that are already hard at it. Here are a few data points that have me gravely concerned about the state of the Chinese market (just as I was in 2007):
- Last week, Bloomberg reported that across the 144 companies that have gone public on mainland Chinese exchanges in 2015, the average share price gain year to date is a stunning 539%.
- Yesterday, Bloomberg reported that the aggregate market value of stocks traded on Chinese exchanges has increased by $6.5 trillion over the past 12 months. The increase is equivalent to roughly two-thirds of China's gross domestic product in 2014.
- The Wall Street Journal told the story of Chinese money manager Ye Fei, 36, who recruited investors for a new fund, suggesting he could multiply their money a hundred-fold over the next five years. According to the report, "the fund sold out soon after it launched last month [in April]." Ye shuttered his previous fund in 2012 after racking up a 64% loss.
In general, I'm a fan of index investing (I think it's the best strategy for most investors), but being forced to buy and hold shares regardless of their valuation becomes a dangerous proposition when the stock is highly overvalued, which is the case today in China. If MSCI says "yes" to China, Chinese stocks might get an extra boost from the resulting money inflow; however, the incremental gain will be of no comfort to investors once this overheated market corrects (as it will, inevitably).