Last week, following Wednesday's drop in the U.S. market, the Hang Seng Index in Hong Kong dropped 3.2%, and the Shanghai Composite Index lost 4.9% -- its biggest one-day decline in four months. It's clear that the Chinese market is tied to the U.S. and vice-versa, through trade if nothing else. But the connection also goes the other way, and I think that the Chinese stock market implosion that is coming will be another force dragging down U.S. markets.

In 1997, when Great Britain handed over Hong Kong to Chinese rule, Hong Kong stocks rallied sharply for the six months before the transition, and everyone bought the "red chip" stocks that had strong connections to the mainland. About two weeks after the turnover, that bubble popped.

This one is worse. Shanghai Exchange investors have not been able to buy stocks outside of the mainland, and they've never been through a bear market. They think stocks only go up, with dips like yesterday just providing a chance to buy more shares cheaply. They mostly buy the state-owned companies because they appear connected and protected. In reality, many of those companies are technically bankrupt or don't make any money under honest accounting.
Consequently, shares of a stock like PetroChina (PTR) trade on the Shanghai Exchange at a premium to what they trade for in Hong Kong or on the NYSE. How much of a premium? Triple. You read that right. PetroChina is worth 200% more at Shanghai prices than in Hong Kong or New York. Based on the Shanghai price, the company is worth $1 trillion. That, my friends, is a very big bubble. Warren Buffet recently sold all of his PetroChina shares.

As you know, some of the mania has spilled over to Hong Kong, because China was about to allow mainland investors to buy on that exchange. But over the weekend, Premier Wein Jia-bao said that Beijing needs to do more research and planning before changing the rules for individuals. Whoops! The 50% run-ups in individual Chinese stocks over the last three months suddenly look a tad enthusiastic. Mutual funds will still be allowed to invest in Hong Kong, and I suspect it could be years before the rules are changed for individuals. Between now and then, I am still looking for a huge correction.