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Is China's stock market overheated?

Stock market fever is sweeping China.

Chinese equities are officially on fire. The Shanghai Composite has skyrocketed 78% since just before Halloween. It recently crested the 4,000 level for the first time since the financial crisis.

Yet stocks in China have achieved red-hot status just as the country's economy is going through a cooling off period. Growth slowed to the weakest pace since 2009.

In other words, exuberance for Chinese stocks isn't being backed up by fundamentals. Instead, the market is being carried higher by various forms of government stimulus and investor frenzy.

All of this raises the question: Is China in the midst of a bubble? And if it is, what should American investors do?

"Certainly a bubble exists," said Ankur Patel, chief investment officer at R-Squared Macro Management.

Rather than enjoy the ride up or try to profit from its eventual popping, Patel said the prudent move for U.S. retail investors is to stay away from the Chinese market altogether.

"The problem with any bubble is if you try to bet against it, bubbles can become even more irrational. The herd mentality can essentially run investors over," he said.

Equity euphoria hits China: There are growing signs of speculative fervor in China.

In recent years, people in China -- who tend to save significantly more than their Western counterparts -- sunk their excess savings into the real estate market.

Now that the bubble in housing is deflating, they are latching onto the skyrocketing stock market. Investors opened 4.8 million new stock trading accounts in March and then another million more in early April, according to the Financial Times.

"There's no question there's a lot of domestic euphoria about equities within China," said Albert Brenner, director of asset allocation strategy at People's United Wealth Management.

Several Chinese retail investors polled by CNNMoney said they trade stocks frequently -- up to several times a day -- in part to have fun. One Shanghai woman, who didn't give her full name, said she's not worried about trading expenses hurting performance because "fees tend to drop during bullish markets anyway."

Non-Chinese investors are also taking notice. Exchange-traded funds that track China -- the best way for U.S. investors to play China -- have soared. The iShares MSCI China ETF (MCHI) and SPDR S&P China ETF (GXC) are both up over 20% so far this year.

Liquidity-fueled bubble? Hoping to avoid a so-called "hard landing," China's central bank is pumping liquidity into the market by cutting rates. That's good for risky assets like stocks, but liquidity-driven moves are susceptible to bubbles.

Liquidity is also being pumped by the Hong-Kong Shanghai Stock Connect Program, which allows investors to buy Shanghai stocks through Hong Kong -- and vice versa. Not only is fresh foreign capital flowing onto Mainland China for the first time, but excess liquidity inside China is flooding into Hong Kong.

Source - Money CNN