The Chinese New Year doesn't arrive until February 18th, and considering that the Chinese stock market doubled in 2007, while our own volatile yet underwhelming market has taken more than ten years to accomplish the same feat, perhaps we should focus more on other countries' goings-on.

Certainly, fund companies (and fund investors) have set their sights on more exciting opportunities abroad. In the last two years, we’ve seen the launch of no less than five funds with China in their names, and many more with significant investment in the region. But then again, fund companies have a history of arriving at the party well after the ball has dropped and the champagne run dry.

One of the goals of the MAXadvisor Powerfund Portfolios is to avoid overheated markets. This is often even more important than buying into out-of-favor areas. Sometimes, entire countries are overheated, but more often, it's just certain sectors, styles, or types of stocks that are due for a fall.

Back in 1999 and 2000, we warned investors about overheated tech and growth socks. By 2005, we were sounding the alarms over the bubble du jour – real estate. And in 2008, we begin the year by raising the warnings on emerging markets from mere concerns about elevated valuations to a full-on, bubble-grade alarm.

At the center of the current emerging markets hoopla is China. The story behind all of the new fund launches and hot stock market performance is the outstanding economic growth there. Ironically, the Chinese stock market was caught in a sharp downdraft from 2001 to 2005, even though the country's economy was firing on all cylinders (with a turbo charger and nitrous oxide system to boot).

For reference, in a typical year, the Chinese economy grows around three times as fast as the U.S. economy. Such growth can be used to rationalize higher stock prices, since companies generally earn more money as the economy grows. If we knew that the U.S. economy was going to grow at 10% per year for the next few years, we’d increase our U.S. stock allocations with little reservation. But such growth rates are often unsustainable.

Although we've maintained a positive category outlook on Asia funds in general, we expressed wariness about China in an article way back in 2004 after witnessing a few fund launches targeting China. During the sixteen months following our article, the Shanghai Composite Index fell 40%. Strangely, China was the one real laggard in the whole emerging market boom of the 2000's. Talk about conundrums – it may be the only example in history of a country growing so quickly while its stock market sank so low.

Then 2006 arrived, and it was as though investors around the world suddenly stopped caring about all of the quirks of stock investing in China, like large government stakes and ownership rules in shares for locals and foreigners, that kept them away during the emerging market boom. One of the more amazing things about the whole China fascination is how largely capitalist, free-market types who complain about the implications of relatively minor U.S. government intervention into American business are so quick to embrace investing in a country in which the ties between business and government – communist government no less – remain so tightly intertwined. Perhaps  this is just another proof of our theorem that strong past performance leads people to put their normal thought processes on the back burner.

Now, about two years after the big run started, the Shanghai Composite Index has climbed 500%, although it appears to have hit some sort of Great Wall a few weeks ago, and has since dipped. It’s a run that eclipses the great Nasdaq bubble/rally from January 1996 to March 2000.  

<img src="http://www.maxadvisor.com/images/nas-china.gif">

Somewhere along the way, the total market cap of Chinese stocks exceeded the GDP of the Chinese economy – usually a bad sign, particularly for riskier stock markets and economies with fewer publicly traded companies. 

As if this weren’t enough, a Chinese IPO was recently valued at over $1 trillion dollars – the largest company by market cap in the world. Now we know the U.S. dollar is pretty weak these days, but a trillion bucks is still nothing to sneeze at. In fact, it’s more than GE and ExxonMobil <i>combined</i>. 

But of course, a fast-growing economy rationalizes all excessive valuations, just like fast growing earnings made it okay to buy Cisco (CSCO) or JDS Uniphase (JDSU) at 100 times earnings. Unfortunately, we don’t expect China to continue growing at double-digit rates forever. We’re not sure why this opinion is so novel, but then, we don’t understand how so many smart bankers  thought it was a good idea to lend people money at 6% interest with little money down to buy a home that just doubled in price in a few years.

All this growth leads to bad investments – bad businesses being financed, bad projects being developed, bad valuations being paid. Too much investment capital can be just as devastating for an economy as too little.

If  the piercing pop of the Japanese stock market and the American tech bubble wasn’t proof enough, check out what's unfolding now in the housing market. The #1 cause of that building (no pun intended) catastrophe? An excess of money available for real estate loans. Do you think bankers would let buyers take out a <i>"no doc"</i> mortgage (meaning no proof of income required) if they didn’t have too much money to loan, or investors prepared to buy the loan from them before the ink even dried?

All of this China hysteria reminds us of the excitement over Japan in the late 1980's. Back then, the Japanese economy, companies, and stock market were the envy of the world. Their model was perfect, while ours was broken. How could we compete with the Japanese way of doing business? It seemed that Japan was buying up our country, and swimming in profits from selling us stuff. 

Now, almost two decades later, the Japanese stock market is STILL down over 50%, and with the noted exceptions of the Nintendo Wii and Toyota Prius, we’re not all that envious of their companies, and certainly not their stock market or economy.

We wouldn’t be adding any new money to Asian funds today – including the Asian fund we recommended in our 2007 HotSheet. If this bubble continues, we may even consider shorting China in our Daredevil portfolio – though such a move is very risky. For most, avoiding bubbles is strategy enough.