Quotes of the Day

Although he's 63 years old, Beijing retiree Du Shuzhan is not afraid to try new things. He has just discovered the stock market. A few weeks ago, Du deposited $1,500 in his first share-trading account, and on a recent January afternoon, visited his local broker to buy shares of seven Chinese companies. "All my friends started to invest in the stock market last year," Du says. "My wife and I decided to join the trend." Du admits that, when it comes to deciding which stocks to buy, he lacks expertise. "I don't know much about it. I just picked the ones with low prices." But he figures he'll do fine. "With all the money in the market, I don't see how it could go down."

Ah, such heady optimism. That unquestioning faith in the ability of China's soaring stock market to defy gravity has become worryingly common among Chinese investors—so common that market observers and government officials are warning that a market correction might be on the way. Emboldened by a 130% rise in the Shanghai Composite Index last year—which made Shanghai one of the best-performing exchanges in the world—starry-eyed speculators and first-time punters like Du have been storming into Chinese stocks, ending the market's five-year slump and in recent weeks pushing daily trading volumes to all-time records. Last year, some 2.4 million investors began trading stocks through the Shanghai exchange, a 250% increase in new accounts. That's an average of about 7,000 per day, a flood of fresh blood from san hu (as the Chinese call small investors) that is making seasoned traders nervous. "When you see shop assistants and taxi drivers racing out to borrow money to buy stocks, you've got trouble," says commodities guru Jim Rogers. "That's the market sucking in a whole lot of neophytes priming to get slaughtered."

Plenty of stock analysts and fund managers disagree, arguing that prices are simply keeping pace with China's remarkable economic rise. The country's GDP grew 10.7% last year, the highest rate since 1995. But the bulls are increasingly being drowned out by those who see the kind of reckless speculation that often occurs in overheated markets. Beijing officials, worried there could be another Chinese market meltdown like one in 2001 that soured the public on stocks for years, are sounding the alarm. On Dec. 30, Cheng Siwei, a vice chairman of the National People's Congress, cautioned investors against "blind optimism" in the country's relatively underdeveloped capital markets. Last week, China Central Television, the government TV network, broadcast a show warning citizens not to use their homes as collateral for loans to buy stock. Authorities are doing more than jawbone—bank lending for stock purchases was barred last month. Regulators also temporarily halted the sale of new mutual funds.

Beijing may have good reason to apply the brakes. In frothy markets, investors tend to form unrealistic expectations about companies' prospects because they buy into an ill-founded theme, whether it be consumer demand for tulip bulbs or, in this case, the notion that China's economic growth is boundless. David Webb, an independent investor based in Hong Kong, says that's what's happening with many China stocks. "Once you get past the hubbub, the fundamentals behind these prices just aren't there," Webb says.

Take the country's largest life-insurance company, China Life, which trades in Shanghai, Hong Kong and New York. On Jan. 31, China Life shares had a price/earnings ratio of around 70 (a stock's P/E ratio measures the amount investors are paying for every dollar of per-share earnings). That's a richer multiple than investors are shelling out for fast-growing Google, the investing world's flashiest Internet phenomenon. Nor are high prices confined to just a few Chinese stocks. Webb estimates the average P/E for so-called "A" shares (stocks available to mainland investors on China's Shanghai and Shenzhen bourses) at 34; the current P/E for U.S. stocks in the S&P 500 Index is 18. Want more proof? According to a recent report by investment bank JP Morgan, out of 37 Chinese companies listed jointly in Shanghai and Hong Kong, eight trade on the mainland at valuations at least double those quoted in Hong Kong. "The risk-reward picture is unhealthy at the moment," says Frank Gong, JP Morgan's chief economist for China. "The market has undoubtedly moved ahead of itself."

Not surprisingly, comparisons are being drawn between China's stock boom and the U.S. dotcom bubble of the late 1990s. Certainly there are similarities, such as a frenzy for initial public stock offerings. As investor demand for Chinese stocks has intensified, so has the list of mainland companies eager to cash in on the mania by going public. In 2006, Chinese companies raised more than $53 billion in the Hong Kong and Shanghai markets through IPOs and secondary share offerings, up from $24 billion the year before. Among them was the largest IPO in history, November's $22 billion listing in Hong Kong and Shanghai by Industrial and Commercial Bank of China (ICBC). Despite the fact that Chinese banks are known for their lack of transparency and weak management, ICBC was a wild success. Its share price at one point soared 70% above its initial offering price of 39¢ in Hong Kong. That pushed the bank's market cap so high that for a while it was valued as the second largest financial institution in the world behind giant Citigroup. The appetite for China stocks has encouraged other big corporations to tap the market. Analysts say they're expecting China Mobile, the world's largest mobile-phone company, to issue additional shares this year. Ping An Insurance, China's second largest life insurer, and oil-and-gas conglomerate PetroChina are also expected to issue more shares. There's no way all can be winners, says Nicholas Yeo, a fund manager for Aberdeen Asset Management. "One of these large IPOs last year would have been impressive," Yeo says. "But can they keep pulling them off? Probably not."

If this is a bubble, is it about to burst? Maybe not. Peter Alexander, chief analyst for Z-Ben Advisors, a Shanghai investment consultancy, says Chinese companies are stronger and more efficient than they were a few years ago. "It's dangerous to bet against China," he says. Also, if you exclude China Life and banks that fueled last year's blockbuster IPOs, Shanghai stocks trade at prices comparable to those of Asian companies listed on other regional bourses. In fact, some of China's smaller manufacturing and textiles companies are still relatively undervalued. "Judging from history, the stock market doesn't bust when the buying is concentrated on blue-chip names," says Lan Xue, head of China research for Citigroup. "It's when the buying goes into the second line, third line, fourth line [companies]—the speedy names—this is what would get me more worried." Xue predicts the bull market will continue at least another one to two years.

That's what China's new investors think, too. Punters gathered to swap stocks and stories at the Beijing branch office of the China Galaxy Securities brokerage house on Jan. 29 certainly weren't letting a small drop in the market that day dampen their spirits. "I guess the fluctuation will go on for a while, maybe for another month or so," says Jiang Yulan, a trading aficionado, "but in a long term, the price will be going up by the end of this year." So confident are the assembled san hu that they don't even consider trading to be serious business. Instead, they use wan, the Chinese word for "play," to describe their activity. If the market tanks, the san hu won't be the first to discover that investing is not a game.

• Kathleen Kingsbury / Hong Kong