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China - Basic Background and Current Issues

(January 30, 2005)

Please note that we switched to a neutral position from a 100% long position in our DJIA Timing System on the morning of January 12th at DJIA 10,530.  No new signals as of now.   The new section on our DJIA Timing System will be completed within the next few weeks.

Two new boards on our Discussion Forum have been created - they are named the “Technical Analysis and Trading Systems” and “The China Board.”  Past postings from “The Bull Board” and “The Bear Board” have been relocated to the “Market Commentary” board.  I believe that the creation of these two new boards will better help our readers learn and exchange investment ideas going forward.  We have also set up a new section for Legend Capital under our “Market Commentary” section.  Legend Capital is an investment advisory/VC firm based in Hong Kong.  Sophia Yan, the deputy manager at Legend Capital, have allowed us to feature her writings on our website - her writings will mostly focus on the Chinese economy and any other interesting Chinese investment ideas.

Dear Subscribers and Readers,

I am planning to take a different approach in my market commentary this week.  I am scheduled to make a presentation this Wednesday evening to a local business organization regarding the investment prospects of China going forward (both in the short-run and in the long-run).  As the title of this commentary suggests, I will use this week's commentary as my “canvas” in order to explore my ideas and thoughts further.  I think it will be a very instructive exercise for Chinese and U.S. domestic investors, alike.  Over the long-run, the best and most profitable way to make money is to find an inefficient opportunity in the market and then buy that investment to hold for a relatively long time (such as buying IBM when it was in the verge of bankruptcy in 1993 or buying Philip Morris in the midst of all the potentially devastating lawsuits in 2000).  Going forward, I believe the Chinese markets will present many dangers for investors - but these dangers will also translate into very profitable opportunities if one can take advantage of those situations - buying when everyone else is selling or selling when everyone else is buying.  Having sufficient knowledge is the key - and I intend to keep track of any Chinese investment opportunities going forward - both for myself and for my subscribers.

For the record, I believe my readers all domestic investors here in the U.S. should learn more about China going forward.  This is why we created “The China Board” - a board which all my readers will be able to exchange their ideas and views on nearly anything about China - economically, culturally, etc. Our main focus, however, is to exchange investment/trading ideas (whether long or short). No doubt, the financial markets in China today are still very underdeveloped - there are many dangers associated with investing in such a market but as the saying goes: "Where there is danger, there is opportunity."

Over the next ten years, I believe my readers can benefit more by knowing about China and Chinese investments than they can by just focusing on the U.S. domestic stock market. There are three reasons:

1) The U.S. stock market is so developed that it is very close to being efficient nearly all the time, except during bubble or post-bubble periods (1999 to 2000 and 2002) when asset prices were priced to extremely overvalued or undervalued levels. Moreover, who got to participate in the Google venture capital process?

2) There are still great inefficiencies in the Chinese financial markets. I believe that in the next decade or so, U.S. high net worth individuals will be able to participate in the VC or IPO process in China if one starts learning about China or start developing the relationships right now. Because there are still great inefficiencies, one can still find many bargains (or many frauds to short) when it comes to investing in China.

3) I am long-term bullish on China, even though I believe the China economy is now very close to over-heating. At this point, I will welcome a Chinese recession since it will present us to pick up Chinese assets at very good prices and then watch them go up for the next 20 years.

I believe we will be able to help our readers as we continually learn about China going forward.  I was originally from Hong Kong, and today, I have many friends and acquaintances that are familiar with the economics and financial markets of China, Hong Kong, and Macau.  We will be able to learn many things from them - things that investment outfits such as Goldman Sachs, Morgan Stanley, Bank of America, Richard Russell, Bank Credit Analyst and millions of U.S. investors don't have an edge in - no matter how hard they try.  Of course, I am not going to promise anything, but at least we will have a much better playing field when it comes to evaluating China.

Today, China is still predominantly an agrarian society, with over 50% of its labor force involved in agriculture.  However, agriculture today only accounts for 20% of GDP, as the country is now known more for its manufacturing capabilities and increasingly services.  According to official statistics (which may be questionable until recently), China has more or less engaged in an even path of GDP growth:

China's Real GDP Growth (%) (1978 - 2004)

It is interesting to note that even with the 9.5% growth rate registered in 2004, this rate is still not comparable to the rapid GDP growth experienced during the 1992 to 1994 period.  However, there are bottlenecks now developing.  Some may even argue that a play on Chinese industry today is more or less a play on the levered U.S. consumer - if rising energy and commodity prices don't kill it first.  In 1994, the Chinese government managed to avoid a hard landing.  The question is: can they do it again this time?

Before I go further, I want to put the explosive growth of China into further perspective.  Firstly, since 1999, China has been the largest consumer of steel in the world markets, surpassing the United States during that same year.  Following is a chart showing selected countries in the world (including the entire EU region) and their annual consumption of steel from 1997 to 2003:

Annual Steel Consumption in Selected Countries (millions of metric tonnes) (1997 to 2003) - Today, China consumes 27% of the world's steel and has accounted for 78% of all the growth in world demand since 1997! Note: 2003 total world consumption = 863.7 million tonnes. Russia is 2nd - accounting for 5% of all the growth in demand since 1997; India is 3rd at 4.9%, and S. Korea (not shown) is 4th at 4.6%.

As shown in the above chart, China has accounted for 78% of the entire world's growth in steel demand from 1997 to 2003.  Most of this demand is coming from the construction and automobile industry.  The other economic miracle that people have been talking about?  India has only accounted for 4.9% of the entire world's growth in steel demand during that same period.  The amazing thing is: With the increase of steel-producing capacity projected to happen this year, China should actually be a net exporter of steel in 2005!  With basically no growth in steel demand in all the developed countries over the last seven to eight years, can the world absorb all this supply?  Overcapacity, anyone (I will delve into more details about this in next week's commentary)?

A discussion about China will not be complete without a discussion of oil.  Following is a chart showing the average daily consumption (millions of barrels per day) of selected countries during the 1992 to 2003 period, including China:

Average Daily Oil Consumption in Selected Countries (MMb/day) (1992 to 2003) - China surpassed Japan as the second largest consumer of oil in 2003 - at an average of 5.6 million barrels per day. Most recently, China consumed oil at a rate of 6.8 million barrels per day in the third quarter of 2004. Demand is expected to grow to 12.8 million barrels per day by 2025. Note: 2003 total world consumption = 80 million barrels per day

The average daily demand of oil coming from the Chinese in 2003 puts them on second place - having just surpassed Japan in that same year.  This is still very far away from demand coming from the United States - a staggering 20 MMb/d (with nearly half of it coming from automobiles).  However, it is interesting to note that the Chinese demand for oil accelerated substantially during 2004, with an average demand rate of 6.8 MMb/d in the third quarter of 2004 (the latest data that we have)!  Keep in mind, however, that the main reason for the latest rise in the oil price is not because of Chinese demand - again, I will delve into this in more detail in next week's commentary.

Recently, the internet was voted as the number one innovation of the last 25 years by a panel from CNN.  Whether you agree with this or not, there is no doubt that the internet is leveling the playing field not only for individuals but also for emerging economies as well.  The ease of access to information is now amazing, compared to what would have been required only 15 years ago.  According to the latest statistics, China now has 94 million internet users - second highest in the world and now only behind the U.S.  The number of internet users in China is projected to surpass the United States in only five years.  China is definitely fully participating in the “New Economy.”  Moreover, it is interesting to note that nine of the top 25 most trafficked websites in the world are from China (according to Alexa.com as of the evening of January 30th) as shown by the following table:

Nine of the top 25 most trafficked websites in the world are from China (according to Alexa.com as of the evening of January 30th)

Guess which website is number 26?  It is also probably one of the most frequented here in the United States - CNN.com.  Moreover, there is no European site in the top 25 list.  Google UK and the BBC News website are ranked 27 and 28, respectively.  But aside from Great Britain, there is no European website until we get to number 49 (Google Spanish).  The next highest European (ex Great Britain) website is Google German at number 61.  Maybe there is some truth after all to the phrase “Old Europe”?

Despite this continued high growth of China and its increasing dominance in the world stage, there are still many challenges and now economic bottlenecks facing China today.  A more urgent challenge is the possibility of overheating - which I will go into further detail in next week's commentary.  Longer-term challenges include the lack of a legal and financial infrastructure and a lack of enforcement where there is (as exemplified by a lawyer per capita ratio of 11,000 to 1 compared to 300 to 1 in the U.S. and 600 to 1 in the UK, and an accounting per capita ratio of 9,650 to 1 compared to 166 to 1 in the U.S. and 412 to 1 in Hong Kong).  The business mentality of the general population and corporate compliance will need to continue to evolve - again, I will discuss this in more detail in next week's commentary.  For now, I am longer-term bullish on China - but short-time wise, I am very worried regarding a possibility of overheating.  For people who are interested, I have posted an email from Ms. Sophia Yan on our Discussion Forum regarding her views on the current Chinese economy.  Sophia is second-in-command at Legend Capital, an investment advisory/VC company specializing in Chinese investments whom are based in Hong Kong.

Now, let's go ahead and discuss the current action in the U.S. stock market.  I am typing this up on Monday morning (since I spent too much time looking at the Chinese economy and markets this weekend) - there is really nothing new to say at this point except that the bears are running out of time.  If this current rally does not end today or tomorrow and we start heading down again, then we may have seen a good ST low last week.  Following is the daily chart of the DJIA vs. the DJTA:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to January 28, 2005) - The Dow Transports had a hard bounce last week - rising 2.15% for the week.  Can the DJTA get in gear?  If not, then potential support isn't around until 3,350 to 3,400 or so. Both the Dow Industrials and the Dow Transports finally broke the string of three consecutive down weeks - with the former rising 0.33% and the latter rising 2.15% for the week.  For the year, the two Dow indices are down 3.3% and 6.6%, respectively.

As readers can see, hard support for the Dow Transports has now moved up from 3,300 to approximately 3,350 to 3,400.  Any further downside in the Dow Transports should be protected at that level.  For now, the Dow Industrials is definitely the stronger index.

Recently, there have been many calls from the bears calling for the end of this cyclical bull market primarily (supposedly) because of the fact that the yield curve is now flattening.  Dear readers, nothing can be further from the truth.  As can be seen by the chart below, the spread between the yield of the long bonds and the Fed Funds rate is still over 2.4%, which is significantly higher than the spreads that we experienced during the entire 1998 to early 2000 period:

Differential Between the Long Bonds and the Fed Funds Rate vs. the DJIA (January 1998 to Present) - The spread between the long bond and the Fed Funds rate has now broken its October 2002 and June 2003 lows - a level not seen since September 2001. But the spread is still many basis points over the differential experienced during the 1995 to 2000 period.

In fact, it is interesting to note that the spread between the yield of the long bonds and the Fed Funds rate were less than 2% during the entire late 1990s - or in other words, during the greatest bull period in the history of this country.  Chart below:

Differential Between the Fed Funds and the Long Bonds vs. the DJIA (January 1993 to December 1997) - The greatest bull market in this country's history occured when the spread between the longs and the Fed Funds were less than 2%.

Now that I have gotten that off my chest, it is now time to update some sentiment charts.  First off, let's look at the Bulls-Bears% Differential in the AAII survey.  The latest reading is now at a negative 10% - the lowest reading since March 14, 2004.  The four-week moving average is now at negative 3.3% - the lowest reading since March 21, 2003.  From a contrarian standpoint, this is bullish.

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey dipped further last week to negative 10% - the lowest reading since May 14, 2004.  The four-week moving average is now at negative 3.3%, the lowest reading since March 21, 2003 (when it was at negative 9.8%).  Some bears are calling this survey irrelevant, but I prefer hard objective readings over opinions anyday - I will not be short here unless I was a bear looking for a market crash (which is always a low probability event).

The Market Vane's Bullish Consensus sentiment survey, meanwhile, is not really confirming the extreme bearish readings in the AAII survey.  The current reading is 61%.  While this reading corresponds with the reading during the late October lows, it is not enough justification for a huge rally going forward.  However, this does not preclude one from happening.  One thing's for sure: I do not want to be short at this stage.

 

The Bulls-Bears% Differential in the Investors Intelligence, meanwhile, are still experiencing relatively high readings, although there is approximately a two-week lag in this reading compared to the readings in the AAII survey.  Hopefully, these readings will confirm in the next couple of weeks, but again, keep in mind that we also experienced similar readings during the October lows.

DJIA vs. Bulls-Bears% Differential in the Investors' Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey had an insigificant increase 31.2% to 32.0% in the latest week.  Compared to the March, May, and August 2004 readings this reading is still relatively high - although readers should keep in mind that we also experienced a similar reading when the DJIA bottomed in late October.

Bottom line: While we are still probably in a defined downtrend, the bears are most likely running out of time.  If the market does not start heading down again early this week, then I believe we have gotten at least a ST low.  For now, I would recommend buying any stocks that one believes offer a compelling valuation.

Signing off,

Henry K. To, CFA

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