Time to Short the Shanghai Composite?

I'm not a big fan of calling the direction of entire markets, but this one seems like a no-brainer. The Shanghai Composite index is way up from its lows in 2005. It rose from its valley near $1110 back in December of 2005 to its peak over $4330 in May of this year. Over the same time period average weekly trade volume on the exchange increased from 8 billion shares to nearly 55 billion. More and more speculative investors are jumping into the Chinese markets with the hope of making a quick buck.

Meanwhile the index has retreated from its peak and has dipped below virtually all of its moving averages to rest at $3776. Why do I think that the index has very little upside at these levels? Well first and foremost the P/E ratio for the index is 39.82, which is clearly in bubble territory. But, the main reason I believe the Shanghai index is overextended is that the Chinese government has shown its willingness to step in when needed to protect investors from themselves. Just last week the Chinese finance ministry tripled the tax on trading to $0.03. The markets did not take the news well, tumbling 6.5% in the first day of trading after the increase. Since then the market is off another 7% as speculators adjust to the new tax and investors gauge whether that relatively minor change is enough to trip up the bull market. Many probably realize that the finance ministry has more tools in their toolbox to curb speculation and if the market tries to test its highs they will be forced to use them.

Remember it was just a year ago that Shanghai real estate was all the rage. However with a series of tax and administrative measures the government effectively chased speculation out of that market. Unfortunately much of that money has landed in the stock market and the government will in all likelihood be just as diligent in controlling speculation as they were in real estate.

Key thing to notice in the chart below: Yahoo! only tracks volume up to 4 billion. You can see that has been inadequate for quite some time.