(This article was originally published on Real Money Pro at 7:25 a.m. ET.)
Investors are constantly faced with questions. Are valuations overstretched? Is the coming earnings season going to be a boom or a bust? What will be the final outcome of the Greek referendum?
Here's one question you won't have to answer: is China's stock market in a bubble? Yes it is. And now that bubble is bursting.
After I wrote about the China stock bubble in April, the Dow Jones Shanghai Index (DJSH) climbed an additional 20%. Those gains quickly evaporated and the path of least resistance is now lower.
That quick rally (and even quicker reversal) makes a point about the nature of bubbles. They can be fantastic money-making opportunities, provided that you understand that you're in one. Making money in a bubble is easy. Keeping it is the hard part. It's a tough lesson to learn and investors in China's markets are learning it now.
What happens next? The DJSH chart alerted us to this bubble and now it projects further downside. Check out the head-and-shoulders pattern (L-H-R) on the DJSH.
In technical analysis, everything is defined by what precedes it. The massive run-up that preceded this bearish pattern makes it all the more ominous. When markets rise with such alacrity, the backing-and-filling action that creates support and resistance levels is bypassed. While this allows a market to rise quickly, that speed of movement is also evident on the downside.
If you caught the MACD sell signal on June 16 (arrow), kudos to you. But shorting this market is also a dangerous proposition. China longs are hoping to sell into strength and they had a brief opportunity to do so at the open last night thanks to the People's Bank of China (PBOC).
On Saturday, China's central bank announced a reduction in its key one-year lending rate of 25 basis points to 4.85%. The PBOC also announced a 50-basis-point reduction in the reserve requirement for many banks. This led to a brief rally at the open last night before another day of devastating losses.
Could it be that the PBOC saw this plunge coming and was attempting to cushion the blow? CNN, citing BNP Paribas, recently reported that traders in China are opening an average of 170,000 new trading accounts per business day. That's 10x last year's rate. China's stock market is brimming with novice investors and novice investors tend to be poor risk managers. Expect a cascading series of margin calls to drive China's markets even lower.