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Solving the Chinese Riddle

(May 18, 2006)

Dear Subscribers and Readers,

Subscribers please note that a real-time “special alert” email was sent out on Wednesday morning informing you of a change in our DJIA Timing System from 100% short back to a 75% short position at a DJIA print of 11,255 – giving us a gain of 355 points of the final 25% short position that we initiated last Tuesday at 11,610.  In the short-run, the market is very oversold – as exemplified by a daily NYSE ARMS close of 1.97, a 21% spike in the VIX, and a daily NYSE McClellan Oscillator reading of – 223.68.  As we have mentioned before, we were looking to bring our total short position in our DJIA Timing System back to a more “manageable” of 75% - and today, we got such an opportunity to do that.  Going forward, however, this author would have to say that the internal condition of the market hasn't look this bad since early 2003 – and probability suggests that the market will continue to be mired in a downtrend, even though a short-term bounce is now very much overdue.

Now, let's get to the gist of our commentary.  Long-time readers should remember that one of the original purposes of us starting this website was to keep our readers informed on current investment trends in China – as well as developments that American and other global subscribers truly care about, such as the continued development of the Chinese economic engine, the Chinese labor force, offshoring and outsourcing and they will affect our everyday lives.  Unfortunately, most of our subscribers cannot truly take advantage of direct investment trends in China – whether it is through speculation on the Chinese Renminbi, Chinese real estate, or through physically investing in a business in China (which I do not recommend for folks who don't have the appropriate economic and political connections).  There are, of course, Chinese ADRS that are traded on the NYSE – but the selections are limited and aside from the bottom of the technology bust in October 2002, many of these stocks have not been at “fully oversold” and capitulation bottoms for a long time.

Nothing excites this author more than the chance of buying an individual stock or an “asset class” right or near a secular bottom.  And this is especially true with emerging markets – whose business cycles are typically leveraged to the performance of the U.S. and world economy.  That being said, this author typically gets edgy when a certain emerging market starts to become overvalued (such as the India market where P/Es are now higher than U.S. P/Es) or when investing has become momentum-oriented.  Historically, investing in emerging markets has been a loser's game for most people – and thus emerging market shares have typically traded at a discount to U.S. stocks.  The situation has now reversed, with India leading the pack but with China not far behind.  The following chart courtesy of Morgan Stanley shows that off-shore Chinese equities have had a banner year so far, even as annual earnings revisions over the last month have only increased by 4.4%.  Note that P/E ratios of off-shore Chinese shares (excluding oil) are now higher than they were during January 2004, the last time we had a feeding frenzy in Chinese-related shares (when the China Fund traded at a 50% premium to its NAV):

MSCI China FY1: A Significant P/E Re-Rating

Winston Churchill once said of Russia: “Russia is a riddle wrapped in a mystery inside an enigma.”  Investors all over the world (including George Soros) learned this lesson the hard way in 1998 – when Russia defaulted on its foreign debts against the expectations of many financial analysts and hedge funds.  The Russian default indirectly caused the demise of Long-Term Capital Management.  Combined with the crisis going on in Brazil in 1998, these three events were collectively responsible for triggering a 20% slide in the U.S. stock market from April to October 1998.

So what has investors learned from the 1998 Russian crisis?  Apparently, not much – as the Russian market has continued to embark on an exponential path even as oil has stayed relatively flat over the last six to nine months (and at the same time, natural gas is now only trading at slightly over $6 per MMBtu on the NYMEX).  In fact – even with the latest two-week decline – the Russia market is still approximately 70% higher than where it was when Hurricane Katrina and Rita made landfall:

Russian Trading System (RTS) Index ($RTSI) - Hurricanes Katrina and Rita make landfall; oil spikes to $70 a barrel and natural gas spikes to $15/MMBtu.

Make no mistake: Russia is no Canada.  Well, it also has a natural supply of timber – but the comparison ends there.  Today, Russia is experiencing the worst demographic decline since the Stalin purges.  Russian youths and talent are leaving the country in droves, while the Russian elderly is being left behind to rely on the welfare state to survive.  Corruption within the government still runs rampant.  The New Year's natural gas shutdown to its Ukraine neighbor has also dented its reputation as a reliable long-term partner of energy to the rest of Europe.  This is now all coming in the midst of a record IPO pipeline, as 30 Russian companies are expected to raise $22 billion by selling shares in their companies over the next 18 months.  And to top it all off, some folks are now asserting that the Russian Ruble may now displace the US$ as an international currency in crude oil trading!  President Putin has vowed to develop a Ruble-denominated oil and natural gas exchange in Russia, and asserted that Russia needs to be an “innovation-based” economy going forward.  I believe Russia is moving in the opposite direction.  The chances of Russia doing either of this successfully are just slightly higher than the opening up of the “Iranian Oil Bourse.”

The Chinese Riddle is no different – as the Western world has been salivating on the prospects of selling goods to China for the last two centuries.  And they still are.  Today, doing business in China is as difficult as ever – and is virtually impossible for any Westerner unless you have a strategic relationship with someone you trust locally as well as the appropriate political and economic connections.  But make no mistake: This author believes that China has finally learned her mistakes of the past – the “economic revolution” that Deng Xiaoping kicked off in the late 1970s has allowed the Chinese economy to experience 8% to 10% GDP growth over the last 30 or so years – ending a secular decline which began during the reign of the Qianlong Emperor during the late 1700s.  Going forward, however, there will be many issues to deal with (such as environmental degrading and the maldistribution of wealth and income between the Eastern Seaboard and the inland provinces), but the most important of all would be to finally develop a viable Chinese consumer market – given that China's (and the world) economy is still more or less relying heavily on the American consumer today.

Let me now discuss another Chinese Riddle: The Chinese economy has been very resilient since a slowdown in 1994 – will it continue to grow as quickly as it had been given that the American consumer is now showing signs of a significant slowdown – a slowdown that has not been seen since the last consumer-driven recession in 1991?  What will happen to the domestic investment and real estate boom?  Not only has there be a widespread “recycling” of its Balance of Payments surpluses into property and other fixed investments, many businessmen and speculators have most likely gone beyond this and borrowed in U.S. dollars to fund their investments.  This somewhat makes logical sense, as these folks are expecting a two-pronged effect for their investments: a continuing rise in property prices as well as an inevitable rise in the Chinese Renminbi against the U.S. Dollar.  This is also reinforced by empirical data, as U.S. dollar reserves in China have been growing significantly higher than the growth of its trade surplus with the U.S. over the last few years.

In a U.S. consumer slowdown scenario, China's balance of payments with the U.S. will inevitably decline – and so far, no emerging market country (including Taiwan in the 1980s and Thailand in the 1990s) has emerged from such a boom unscathed.  Will China be any different?  At this point, this author has to answer “no,” but given the lessons of the past, China can definitely cushion this blow by encouraging domestic consumption – such as further reforming the financial sector (by developing the necessary infrastructure for the consumer that is based more on credit than cash, which they are already doing) or by privatizing many of the government-owned assets (equivalent to 100% of GDP) to the general Chinese population at rock-bottom prices.  Such a “scheme” is not totally unprecedented – as Margaret Thatcher and the British government embarked on a very similar policy (by selling subsidized housing to tenants at rock-bottom prices) during the 1980s.  Not only does this increase household wealth – such a scheme will also bring many of the “deprived” households into the capitalist fold.  After all, who doesn't want rising housing prices when you physically own one that is free and clear?  The financial structure will definitely be there in the long-run, but this author doubts that it will have any significant effect on increasing Chinese consumption over the next 12 to 18 months (as the U.S. consumer slows down).  Given the rise in commodity prices over the last six months (copper imports into China are down 20% year-over-year in the first four months of this year), this author would have to say that both Chinese property and fixed investments (such as auto manufacturers, steel producers, etc.) are going to be in for a hard landing over the next 12 to 18 months.

As for the U.S. and international stock markets, we are now definitely in very oversold territory in the short-run.  But that is all in the short-run – the market will inevitably stage some kind of relief rally in the next week or so, but it remains to be seen whether any upcoming rally will be sustainable.  Based on my commentaries and analysis over the last few months, this author would have to say “no” – and that any upcoming rally in the next week or so will only be a relief rally – a relief rally that will lead to significantly lower prices over the next few months.  Over the intermediate-term, the market is still only at neutral levels – and has further room to fall before this author would even think about going into the long side.  More details to come in this weekend's commentary.

Signing off,

Henry K. To, CFA

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