The key to any asset bubble is the flock mentality of investors. A certain way of thinking becomes lore. As asset prices continue to inflate, a flow-on effect is caused – as the asset’s price is going up, people assume that it must be a good investment. In a sense, foolishness encourages even more foolishness.

The epicentre of the current boom is in China (and in a sense, flowing onto Australia), epitomised by the Shanghai sharemarket which is currently trading on the absurd multiple of 50 times earnings. This compares with 18 times earnings for the US market and around 15 for Australia.

Stock mania has hit the Chinese like tulips hit the Dutch. Forbes noted that “Chinese households have around 22 percent of their financial assets in stocks compared with 8.6 percent in 2005.” Forbes also claimed that the “first day returns for Chinese IPOs have averaged 192 percent”. In mid-2005, the Shanghai Composite index was trading at around 1,000 points. Last month, the index cracked 6,000. That’s right – the index itself has managed to become a six bagger in little more than a year.

The boom though has in recent times started to lose some of its lustre. Stephen Wyatt wrote in the AFR today that:

Mid-year, when the Shanghai market was soaring higher, there were queues of thousands at brokerage houses all over the country, jostling to open new accounts. Terminals used to place orders in brokers’ dealing halls were impossible to get to… But no longer. There is no line for new accounts now…

Zhang Qinghai, Shanghai tourist guide and part-time stock trader, says “Many, many people have lost in this recent fall and this is not the bottom. Many have lost half their money. But there is not far to go”.

The Shanghai market has eased off on its highs, falling from 6,000 in October, to around 5,250 now – technically a correction. Despite the drop, the market is still trading on an average PE of more than 50.

Bullish analysts claim the oft repeated mantra that with a population of one billion, China won’t stop growing any time soon. The claim sounds eerily similar to when Henry Blodget and Jack Grubman were extolling the virtues of telcos and dot.coms in 1999. Or when analysts feted the Asian Tiger economies in the mid 1990s, only to see Malaysia, Thailand and Singapore soon fall in to a heap as a currency crisis exposed their under-regulated over over-speculated economies.

The fact remains, China’s growth is largely spurred by US imports. As Forbes noted, “China, is still driven by direct and indirect exports to US consumers. Local middle classes aren’t big enough yet or likely to be for at least a decade to generate domestically led growth, much less promote US expansion through massive imports from America.”

With many predicting that the US may fall into recession in the coming year, the unstoppable China may just hit a brick wall. Stronger forever? Unlikely.

Disclosure: The writer has a ‘short’ position on the S&P/ASX200.