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China - Basic Background and Current Issues, Part II

(February 6, 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. My partner, Rex Hui, is currently in Hong Kong and so the new section on our DJIA Timing System won't be finished until he gets back from Hong Kong (middle of next month).

Dear Subscribers and Readers,

I would first like to welcome the two dozen new subscribers or so of this commentary who attended my presentation about China at the Houston Asian Junior Chamber (Houston Jaycees) General Meeting last Wednesday evening. I apologize for being so wordy - there are a lot of things to talk about which I think I needed to cover. I could've used more graphs - but honestly, I was pressed for time on Wednesday afternoon so I didn't get a chance to create any additional graphs. The important thing was that I got my point across - hopefully, the presentation was helpful.

For my new members, I would like to give you a brief introduction of our commentary. With the help of my partner, Mr. Rex Hui, I basically write a twice-a-week commentary about the U.S. domestic stock markets. On Sunday evenings, I write a commentary about the fundamental and technical conditions of the broad market - and their implications going forward. On Wednesday evenings, I tend to mostly write about a given industry or an individual stock. Sometimes, I write about specific "big picture" issues that I believe will affect all my readers going forward. The "China theme" that I wrote about last week (and further this week) is an example of one of these "big picture" issues. While I think highlighting these "big picture" issues is important for us both as an investor and as an everyday U.S. citizen, my main focus is still the U.S. stock market and individual stocks.

In last week's commentary, I gave my subscribers/readers a little bit of background about the Chinese economy today and how it compares with the rest of the world. My conclusion was: China is the real thing and the increasing dominance of China over the next few decades will have profound implications for the rest of the world (including the U.S. and her citizens) going forward. I will now continue with this theme by highlighting more facts and what I believe are some challenges for China and the Chinese economy today. In next week's commentary, I will conclude with a talk on the most popular misconceptions about China, as well as a talk about various investment ideas - investment ideas that I believe would take advantage of the continuing economic boom in China over the next few decades.

In last week's commentary, I discussed the prevalence of the internet in China - a point which I believed provided further evidence that the China story is real and that China is catching up to the rest of the world when it comes to competing in "the Information Economy." This point is further reinforced by the fact that China today has the highest number of mobile phone users and the greatest number of land lines in the world today. China's impressive development of its infrastructure is not only restricted to the "virtual economy," however, as its national highway system today has 18,000 miles of paved highways. While this number is still significantly (very significantly, in fact - since the U.S. has 160,000 miles of paved highways) lower than the miles of highways in existence in the United States, it is enough to give them a ranking of number two in the world. China also has plans to have 51,000 miles of highways built by 2008.

The Chinese has also been making a great deal of effort to build up their educational system. Today, China is ranked number three when it comes the number of undergraduate and post-graduate degrees awarded in the science and engineering fields. Following are two graphs created by the National Science Foundation illustrating this fact:

China is ranked number three when it comes the number of undergraduate and post-graduate degrees awarded in the science and engineering fields.

Please note that the above data is as of the year 2001. The number of undergraduate degrees awarded by the Chinese in the science and engineering fields (first chart) is probably now greater than that awarded by the Japanese. During that same year, English was introduced into the primary school curriculum - and is now required teaching from the third to sixth grade. In addition, policemen and taxi-drivers, as well as government officials in Beijing, have been asked to learn English as the city prepares for the 2008 Summer Olympic Games.

As one can see, China has made a lot of progress since 1978, and given her emphasis on the continuing education of her citizens in science, engineering, and now in English, she is making sure that the foundation for continued success is solidly in place. The entry into the World Trade Organization in 2001 helped solidify China's role in the globalized world even further. A lot of Americans do not know this, but China definitely got the short end of the stick when they agreed to join the WTO - i.e. they made a lot of concessions - but which I believe will benefit them in the long-run, as it will force Chinese domestic producers to become more efficient and competitive. This will eventually allow them to compete successfully in the globalized economy (without the advantage of low wages which they will eventually lose).

What kind of concessions? The most sweeping series of concessions that they made were in the agricultural sector. For example, the average statutory tariff rate was reduced from 22% to 14% - with an extraordinarily low tariff rate of 1% on important products like wheat, corn, rice, and cotton. Above quota rates are 43% for the former three commodities and 40% for cotton, but these are significantly lower than the Japanese, European and American above quota rates (e.g. the above quota rate for EU wheat is 150% while for Japanese rice and wheat is 350%). The Japanese rice markets are still essentially closed to foreign imports.

China has also committed to reducing its average statutory tariff rate on industrial products to 8.9% - compared to 30.9%, 27%, 32.4%, and 36.9%, respectively for Argentina, Brazil, India, and Indonesia - who are also large developing countries similar to China in many ways. For the first time, China will allow foreign investments in the telecommunications industry with a 50% limit on paging services and 49% limit on mobile services and domestic and international wired services (they have not allowed this in the past for national security purposes). Other industries that the Chinese have opened up include the financial, distribution, and professional services industries. From an economic standpoint, China is now a much more open economy than other countries like Japan, India, countries within the EU, and even the United States.

Not everything is well with China, however. Despite her phenomenal growth over the years, this author fears that there may be some overcapacity in investments and in capital spending, at least in the short-run. For example, the supply of automobiles in China (nearly 5 million vehicles) is projected to be double that of demand this year. There are now 300 auto manufacturers in China and prices have already been cut by up to 20% since the beginning of this year.

I have also mentioned this before, but despite China being the world's largest consumer of steel, China is now expected to be a net exporter of steel for the first time this year. Production capacity is expected to increase to 300mm metric tonnes by 2006. Meanwhile, demand has "only" been growing at a 5% annualized rate for the last few months. Steel companies around the world (except for production in Western Europe and the U.S.) are also ramping up supply at the same time. The fact that there is also an oversupply of automobiles sitting at dealers' parking lots makes this situation doubly troubling.

Another developing and structural problem for China is the existence of a "skills gap" between the unemployed labor force and the workers needed in China's manufacturing, electronic, and textile industries. Let there be no mistake - today, China has an unemployed labor force guesstimated to be in the range of 150 million to 200 million people (greater than the entire labor force of the United States at 148 million people). However, it is to be kept in mind that workers are not interchangeable between different industries. The skills that are required on the farm are different to those, say, skills needed in the manufacturing sector (readers may be interested to know that the type of workers that are in the highest demand are young women in the age 18 to 30 group - precisely the most suitable type of worker for the light manufacturing, electronics, and textiles industries). In the short run, the current shortage of labor in the manufacturing, electronic, and textiles industries is due to the fact that the last two rice harvests in China were strong - coming to the rice harvests during the prior seven-year period where yields have been declining every year. Workers from rural areas are now demanding an average wage of Rmb1,000 a month in the factories - up from Rmb600 a month last year. This relatively high amount of wages is here to say - unless China experiences a devastating drought in the upcoming year.

However, the shortage of labor is also a structural problem for another reason: demographics. We have all heard widely about the aging of the world population, especially in countries like Spain, Japan, and other parts of Western Europe. The United States is also aging, but because of our relatively lax immigration policy, we are still relatively far away from such a problem. China is in a similar situation as the United States, but then again, the United States never had a "one-child policy." Not only will China's population age relatively quickly going forward, but it should be noted that boys have always been favored over girls from a traditional Chinese standpoint. A significant number of girls that have been born in the last 20 years have either been put up for adoption (overseas) or have been murdered - and thus, it is no coincidence that China is today lacking a significant number of girls between the age of zero and 25. This is a structural problem which will continue for at least the next ten years - at least until China is able to compete in other ways (apart from using the weapon of low wages for low-skilled workers) in the globalized economy (such as in the fields of biosciences or software programming).

From a financial/money standpoint, this author is getting worried because the cost of money is also increasing domestically in China. For 2005, China has a target money supply growth rate of 12%, which is significantly lower than the historically growth rate of the money supply over the last five years. Following the policy of the U.S. Federal Reserve, the People's Bank of China should also continue to raise rates going forward (it has also removed the ceilings that banks can charge customers in the last twelve months). This should put a damper in the continued growth in capital spending going forward, and since capital investments make up 45% of GDP (compared to only 16% in the U.S) - any slowdown in investments will not be sufficiently replaced by an up tick in consumer spending (keep in mind the classic GDP formula of C + I + G + X - M). In a way, a play on China right now could be viewed as a play on the levered U.S. consumer.

From a macroeconomic and structural standpoint, please keep in mind that China has only "opened up" its economy since 1978. There is still a lot of work to be done - for example, there are still a lot of legal and financial infrastructure/institutions which are lacking in China and which we take for granted here in the United States. This is not the fault of the Chinese - it took America decades for her to achieve what she has achieved today. While China has a model (in the form of the U.S. and Hong Kong) for a capitalist economy, it is still going to take decades before China has any hope of catching up to the U.S. in this regard. For example, despite their huge markets and further potential, "new economy" companies like Sina, Sohu, Baidu (which has announced its intentions to do a $200 million IPO on either the NYSE or the NASDAQ), and NetEase had/has to raise money in the U.S. equity markets. This view is reinforced by John Thornton, former co-COO and President of Goldman Sachs, now teaching at Tsinghua University in Beijing (one of the most prestigious universities in the country) states that: "... I have probably 20 CEOs in my class, all of whom built their own companies, ranging from small to large. When you ask them where do they want to end up, 20 out of 20 say they want to be a public company on the New York Stock Exchange or NASDAQ, or possibly Hong Kong. None ever says Shanghai." The lack of institutions and a lack of resources to enforce whatever China has is reflected in the statistics such as the lawyer per capita ratio, which is 11,000 to 1 compared to 300 to 1 in the U.S. and 600 to 1 in the UK; and an accountant per capita ratio of 9,650 to 1 compared to 166 to 1 in the U.S. and 412 to 1 in Hong Kong.

Okay, so much about China. Let's now focus on the U.S. stock market. The market made a decent showing last week judging by the major indices, but the stars were definitely the mid caps and the small caps, as the S&P 400 Mid Cap Index closed within three points of an all-time closing high at 661.70 while the S&P 600 Small Cap actually closed at an all-time high of 329.62.

A note to all subscribers - old and new alike: Just for the record, I believe we will see much more of a trend in the market for 2005. As I have mentioned in all my past commentaries, I don't believe the cyclical bull market is over yet. That being said, I think the year 2005 will probably mark an end in the cyclical bull market that began in October 2002 - whether it happens in the next few months or next ten months. Prior to the end of the cyclical bull market, the market will most likely make a final bull run - a run that will most likely suck in numerous investors that have hesitated to get back into the stock market for the last two years. Therefore, unlike 2004, there will most probably be no need to catch all the minor turning points - and therefore, the style of commentary that I have stuck to over the last eight to nine months may not turn out to be so useful for our readers going forward. Over the course of 2005, I have two main goals:

1) To try to call the final top in the cyclical bull market and get out in time for my subscribers. At this point, I am not sure what external factors may trigger the end of this cyclical bull market. But one thing's for sure: This bull market will only die in exhaustion - and it will be blatantly obvious (ironically, so blatantly obvious that the public will blow it off). Similar to my calls in February to April of 2000, I intend to be there for my subscribers when this cyclical bull market ends. Doing so will require less day-to-day watching of the stock market and will involve more "big picture" investing and being patient. The question to ask is this: Should we go long if believe that the cyclical bull market will most likely end sometime in the next ten months?
2) Focusing more on industries and individual stocks - and to be able to exploit various inefficiencies in the stock market. Two examples from last year stick out in my mind. The crash of the Indian stock markets in mid May and the crash in the post-secondary educational stocks in August of last year. If one had bought the popular Indian ADRs or the most popular post-secondary educational stocks when those two events unfolded, then one would have done very nicely last year. I missed out on both opportunities last year since (of course, there are other reasons as well) I was too focused on just watching the technical conditions of the U.S. broad markets. I am not going to make the same mistake this year - especially since I believe there should be more of a trend (a very significant uptrend followed by a very significant downtrend) in the stock market this year. Two potential inefficiencies that I am seeing today include the drug sector (MRK, PFE, and BMY) and the darling of the early 2000s - Krispy Kreme Donuts (KKD). If readers have any other ideas, please do send them on.

Therefore, I will try to focus more on doing research on individual stocks or individual industries during 2005. That is, I will try to utilize more the Warren Buffett style of investing instead of the Jesse Livermore style. Over the long run, value investing is probably the best way to go. Of course, I will also utilize my technical skills to the fullest extent in order to try to call the top in this cyclical bull market in the next ten months.

Long-time readers of my commentary know that I have always liked to cite the Dow Theory in my commentaries. New subscribers can read a brief history of the Dow Theory on this website, so I will not go into further details here. Under the Dow Theory, valuation and the primary trend will prevail over the long-run, but in the short-run, I have always like to compare the action of the Dow Jones Industrial Average vs. the Dow Jones Transportation Average in order to get a clear idea of what's currently happening in the stock market. Following is a daily chart of the DJIA vs. the DJTA from January 2003 to the present:


Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to February 4, 2005) - After a hard bounce last week, the Dow Transports only enjoyed a slight uptick in the latest week - rising 0.6%.  Since the beginning of the year, the Dow Transports has been the weaker index.  Is the Dow Industrials finally going to take over the leadership?

Like I mentioned in the above chart, the Dow Transports has been the weaker index this year. Is the Dow Industrials finally going to take the leadership away from the Dow Transports? One's thing for sure: The Dow Industrials is only 0.6% away from a new 52-week high, but if the Dow Transports cannot confirm on the upside by bettering its all-time high made on December 28, 2004 within the next few months, then there may trouble right up ahead. For comparison purposes, in the last cyclical bull market, the Dow Transports actually made a high in May 1999 while the Dow Industrials made high after high with the Dow Transports confirming on the upside. This went on for eight to ten months before the market started its collapse. The Dow Transports may just be the canary in the coal mine if this cyclical bull market is to end within the next ten months.

I will now go on and discuss the popular sentiment indicators out there. Let's first discuss the Bulls-Bears% Differential in the American Association of Individuals Survey. Following is the latest weekly chart showing the sentiment readings per the Bulls-Bears% Differential in the AAII survey vs. the DJIA:


DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey rose from negative 10% to a positive 17% this week - which is still relatively low from a historical point of view. The four-week moving average is now at 0.3% while the ten-week moving average decreased from 18.6% to 18.0% - the lowest reading since late October. Bears were calling this survey irrelevant as late as last week (which I mentioned in this commentary), but like I said, I prefer hard objective readings over opinions anyday - hopefully, bears who shorted got out of the way just in time (unless one was short Amazon, of course).

The latest Bulls-Bears% Differential rose from negative 10% to a positive 17% in the latest week - showing that individual investors are now starting to get optimistic again. That being said, a reading of 17% is hardly a concern for the bulls. I will not be too worried about the stock market until this reading increases to at least the 35% level (for example, we got a 42% reading in the final two weeks of December - which preceded the early January 2005 collapse). Just for the record, the 10-week moving average of this reading is currently at 18% - the lowest reading that we've seen since late October 2004.

Let's now discuss the sentiment readings per the Bulls-Bears% Differential readings from the Investors Intelligence Survey. Following is the latest weekly chart showing the sentiment readings per the Bulls-Bears% Differential in the II survey vs. the DJIA:


DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey decreased from 32.0% to 29.2% in the latest week.  Nothing new to say here, except for the fact that the latest reading is comparable to the readings that we got during the most recent low in October.  Moreover, based on this reading, it is too early to call for a significant top in the market right now.

While the latest reading of 29.2% and the last couple of readings from the Investors Intelligence Survey did not get close to the August lows, it got low enough (to the October 2004 lows, in fact) for our comfort when we decided that at least a short-term low was possible early last week. Again, I would not be too worried about the stock market until this reading gets to the 40% range or so (for comparison purposes, this reading got to 40% and beyond for four consecutive weeks during the last three weeks of December and the first week of January 2005).

I will end this weekend's analysis with the latest Market Vane's Bullish Consensus data. Following is the latest chart showing the weekly readings vs. the DJIA, yet again:


DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - The Market Vane's Bullish Consensus reading increased from 61% last week to 64% this week.  Along with the 2.8% rise in the Dow Industrials last week, it is probably safe to say that the 61% reading that we got last week probably indicated at least a ST low (even though we did not get our "ideal" reading of 50%).  For now, the trend is up - and I would not be too worried until this reading increases to at least the 68% or even over the 70% level.

Nothing new to say here - except for the fact that this latest reading in the Market Vane's Bullish Consensus is pretty much confirming with the readings coming from both the AAII and the II surveys that I mentioned above. Again, the recent reading of 61% that we got on January 28th was low enough for my liking, and at this point, I will not be too concerned about the vulnerability of the stock market until we reach the 68% to 70% level in this sentiment survey.

Bottom line: We are now in a defined uptrend - and all of my sentiment and technical indicators are still saying there is further room to run. Remember dear readers, tops are inherently difficult to call, but keep in mind that tops also take a much longer time to form than bottoms - as fear (the emotion which causes people to sell and which ultimately causes to form bottoms) is a much stronger emotion than greed. That is, I believe that there will be ample warning signs before we see a significant top in the stock market. For now, continue to hold on to your long positions.

Signing off,

Henry K. To, CFA

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