An Upcoming Chinese Slowdown?
(August 10, 2008)
Dear Subscribers and Readers,
Let us begin our commentary by reviewing our 7 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 437.68 points as of Friday at the close.
7th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 128.68 points as of Friday at the close.
No doubt most of you have seen at least parts of the opening ceremony of the 29th Olympiad held in Beijing. As many Chinese subscribers can attest to, hosting the 29th Olympiad is much more than a “coming out party” for China and her citizens around the world. The term “coming out party” is a major understatement, especially to those who have studied Chinese history and her place in the world from 2,500 years ago to today. As recently as the beginning of the reign of the Kangxi Emperor in the 1660s, China's place in the world – in terms of sheer GDP, living standards, and technological prowess – took pole position, and had been that way for hundreds of years. By the end of the reign of the Qianlong Emperor (Kangxi's grandson), China's relative place in the world embarked on a very steep decline. This would continue to the 1970s. Given the achievements of the Chinese over the last 2,500 years and until the mid 18th century, it was hard-pressed for any Chinese citizen to say he was truly proud to be a Chinese over most of the last 250 years. True, there were always exceptions, and the Chinese had no shortage of heroes such as Lin Zexu and Wong Fei Hung, but by the conclusion of the First Opium War in 1842, it was abundantly clear that both China and her dynastic system were horribly outclassed by the Western powers.
The tide started to turn (slowly at first, but surely) with the implementation of economic reforms by then-leader Deng Xiao Ping in 1978. By the time China took possession of Hong Kong in 1997, and with the Asia Crisis in full bloom, China has become too big and influential to ignore, especially as other Asian countries were crumbling all around them (Japan fell into recession for the umpteenth time in 1997). By the early 2000s - as the US and the global tech bubble was faltering, and after China was awarded the Olympic games - it has become a crescendo. In 2005, China's GDP (nominal, not on a PPP basis) surpassed that of Great Britain, and ranked number four in the world behind the US, Japan, and Germany. By the end of this year, China's nominal GDP is projected to surpass that of Germany. Obviously, there is still a lot of work to do. "Social harmony" remains the long-term goal but this would involve further reforms across the board - not just economic but structural reforms that include a focus on the environment, reforms at the provincial levels, educational reforms, legal reforms, etc. The fall of the Qing Dynasty and the overall dynastic system proved that it was dangerous to rely on a " few great men" (even though it came with a significant bureaucracy) to run such a large country for as long as they live (Qianlong himself was a very good Emperor but turned senile as he got older and continued to hold on to power even though he had officially abdicated). At the same time, the country's leadership is fearful of great change at the governmental level given the sheer amount of blood shed during past regime changes in China. The Communist Party is in name only obviously - but it is a model somewhat based on the old dynastic system with some major differences: Great men at the top are elected by other great men - and no one holds onto power forever. There is no absolute power, but there doesn't need to be as the modern transition of power is relatively smooth and requires no bloodshed.
For now - and for the fist time in 250 years - a Chinese citizen can sincerely claim that he/she is proud to be a Chinese citizen (China's human rights records notwithstanding). For the true nationalist, that dream is still very far away, but China is slowly getting there. It is not about having the world's richest men (e.g. Mexico, Russia, etc.) or the world's largest standing army. It is about becoming a true global citizen - starting with cultivating talent at the science, public policy, and financial levels and bringing on fundamental reforms at the institutional level. From my perspective, it is also about being a driver of sustainable Schumpeterian Growth - such as new breakthroughs in environmental clean-up technologies, green tech, biotech, or in material sciences. It is a long and hard road, but the Chinese understands the sacrifices that need to be made. The Chinese will not rest on their laurels after the 2008 Olympics Games is over, as this “coming out party” is only a first step in reasserting her place in the world. It has been and will continue to be a wild and exciting ride for the Chinese and for the global capitalists going forward (the issue of whether the China needs to embrace democratic reforms can fill a whole book so we will save that for another day).
In the meantime, I believe Chinese economic growth will slow down over the coming months, as the People's Bank of China and the Chinese government continue to try to control inflation and to prevent overheating of the Chinese economy. For example, last Wednesday, the China's State Council revised its foreign exchange rules for the first time since 1997 – allowing regulators to better monitor foreign exchange flows into China's financial institutions and to better prevent “hot money” inflows. Moreover, the Chinese government has continued to try to curb surging housing prices by cutting lending to deter speculation and encouraging developers to build more housing for low-income families. This has resulted in lower real estate transaction volumes across the country, as shown in the following chart courtesy of Morgan Stanley Research:
Furthermore, the People's Bank of China has raised rates six times since 2007 and has kept them at a decade high. It has also raised the proportion of deposits that banks must set aside as reserves to a record high of 17.5% - which effectively acts to cool down the growth in the domestic economy's money supply. Given that the world's major economies – including the US, the Euro Zone, Japan, India, and Eastern Europe – are slowing down as well, there is a good chance that the Chinese economy will see lower-than-trend economic growth for the rest of this year and into 2009.
On July 25th, President Hu Jintao made a speech outlining the Party's goals for the Chinese economy in the second half of this year. Specifically, their first priority is to maintain stable and fast economic growth; concentrate on expanding domestic demand (i.e. Chinese consumer spending), while maintaining steady growth in foreign trade; strive to increase coal, power, and oil supply; guide the capital market and housing market to develop in a healthy way; and to stabilize expectation of economic development. On the face of it, this is a bullish development for the Chinese economy and Chinese stocks. But given the actions of both the People's Bank of China and the Chinese government over the last 6 to 18 months, the dramatic slowdown of most OECD economies, and the threat of a resurgence in domestic inflation (especially energy prices), my sense is that Chinese GDP growth will slow down to the 7% to 9% range in 2009, even though the economy may get a slight bump from the Sichuan rebuilding in the coming months. Finally, an economic slowdown for the host country following the Olympics is not without precedent. According to a recent study by the Bank of China on the last 12 Olympic Games, the host country's annual GDP growth during the eight years after the Games was 0.4% to 2.5% lower than the eight years prior to the Games. With regards to the Games in Asia (Tokyo Olympics in 1964 and the Seoul Olympics in 1988), economic growth in both Japan and South Korea slowed by more than 2% on a year-over-year basis after the Games. Again, while I don't believe that China will slip into a recession after the Games (even the chances of 0% to 5% growth is very unlikely), my sense is that Chinese economic growth will slip to a range of 7% to 9% later this year and into 2009.
Speaking of slowing global economic growth, this is still the message of the MarketThoughts Global Diffusion Index (MGDI). We last discussed the MarketThoughts Global Diffusion Index (MGDI) in our June 22, 2008 commentary (“Oil and the Stock Market”) – arguing that the spike in energy demand and energy prices were not sustainable due to the significant divergence of the action of the MGDI and the CRB Energy Index, the dearth of new production hedges (which take the other side of the long-only speculators and thus serve to dampen prices) due to liquidity and credit concerns, and the overly bullish sentiment in energy and commodities . To recap, we first featured the MGDI in our May 30, 2005 commentary. For newer subscribers who may not be familiar with our work, the MGDI is constructed using the "Leading Indicators" data for 25 countries in the Organization for Economic Co-operation and Development (OECD), as well as China and Brazil. Basically, the MGDI is an advance/decline line of the OECD leading indicators – smoothed using their respective three-month averages. More importantly, the MGDI has historically led or tracked the CRB Index and the CRB Energy Index pretty well ever since the fall of the Berlin Wall. Since our May 30, 2005 commentary, we have revised the MGDI by incorporating the leading indicator for the Chinese economy (we have since added Turkey back into the MGDI since the OECD has again started publishing reliable data for the country). This revision is obvious; as China is now the fourth largest economy in the world and has been responsible for a significant amount of global economic growth over the last few years (its contribution to global economic growth last year surpassed that of the US). So what are the latest readings telling us?
Following is a chart showing the YoY% change in the MGDI and the rate of change in the MGDI (i.e. the second derivative) vs. the YoY% change in the Dow Industrials and the YoY% change in the CRB Index from March 1990 to June 2008 (the July readings will be available on the OECD website in early September). In addition, all four of these indicators have been smoothed using their three-month moving averages:
Note that the immense divergence of the year-over-year change in the CRB Index vs. that of the MGDI (both its first and second derivative) since September 2007 has gotten dramatically wider over the last few months! To be fair, commodity prices have declined substantially during the first week of August, but on a year-over-year basis, the huge divergence is still there (rumor is that Goldman Sachs lost a significant amount on their long energy/short financials positions over the last few weeks). Unless there is a severe supply interruption over the next few months, there is no reason for this continued divergence given the historical (positive) correlation of OECD growth and the rise in commodity and energy prices since the fall of the Berlin Wall. At this point, it is still reasonable to believe that the bulk of the recent rise in commodity and energy prices have been due to speculation, short covering, and the panic over the 1970s concept of “Stagflation,” which few professional economists and forecasters actually understand. More importantly, the recent decline in energy prices should allow China and other emerging market countries to continue to cut price subsidies going forward, thus further dampening energy demand. My sense is that we will see an oil price of $100 a barrel or lower sometime in the next three to four months.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2006 to the present:
For the week ending August 8, 2008, the Dow Industrials rose 408.00 points while the Dow Transports rose 267.28 points. While most of the mainstream media and retail investors are still bearish on the US stock market and economy, the stock market is still holding up relatively well. More importantly, the Dow Transports remains very strong, as it is now only 5% away from its all-time high set just two months ago (vs. 17% for the Dow Industrials). In addition, given the recent deleveraging by the airlines (and thus newfound pricing power), the continuing bottlenecks in the US transportation infrastructure, and the weakening technicals of crude oil prices (oil is only up $1.20 as I am typing this even with the Georgian invasion), I expect the Dow Transports to remain resilient. Given that the Dow Transports has been a leading indicator of the broad market since October 2002, I believe the line of least resistance for both the Dow Industrials and US stocks is still up. For now, we will remain 100% long in our DJIA Timing System – and will only seek to pare back our position if the market becomes more overbought or if our sentiment indicators become overly bullish again.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators increased from last week's severely oversold reading of -21.2% to a -17.6% for the week ending August 8, 2008. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
With the latest weekly reading of -17.6%, my sense is that this indicator has reversed from the historically oversold reading of -22.7% two weeks ago (most oversold level since July 2002). Historically, the most bullish signal comes when this indicator reverses from severely oversold levels – signaling that the line of least resistance for the stock market is still up. Combined with the oversold condition in the global stock market, decent global valuations, the recent decline in energy prices, the sheer amount of investable capital sitting on the sidelines, the record amount of short interest, and the backstopping of the GSEs by the Feds, this reading should be good for another four to six-week bounce in the stock market. For now, I am very comfortable with our 100% long in our DJIA Timing System, and will only pare back our position should the stock market or should our sentiment indicators get overbought once again.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
While the ISE Sentiment Index has bounced substantially since its mid March lows, my sense is that both the 20 DMA and the 50 DMA of the ISE Sentiment Index have now worked off most of their short-term overbought conditions (in fact, the 50 DMA just made a 12-week low). More importantly, both the 20 and the 50 DMAs are still oversold relative to levels over the last five years, and the 20 DMA has finally pierced the 50 DMA on the upside. This is conducive to a sustainable rally over the next four to six weeks.
Conclusion: While the US housing/credit crisis and high energy prices should still be the focus of attention for investors around the world, there is no doubt that the plight of the Chinese economy will also be a huge factor in the months ahead – especially if Chinese economy growth starts to slow down. No doubt, any slowdown of the Chinese economy will have a downside impact on energy and general commodity prices. Moreover, the ongoing and extreme divergence in our MGDI and commodity prices also suggests that the latter will continue to decline for the foreseeable future. Should commodity prices come down meaningfully, there is no doubt that many central banks around the world would also ease aggressively, starting with the Reserve Bank of Australia, the Bank of England, and the Bank of Canada.
For now, I am still constructive in US and Japanese equity prices – and believe that the former bottomed in mid July while the latter bottomed in mid March. Within US stocks, I like the healthcare sector, the asset managers, the exchanges, and semiconductors. For now, we will stay with our 100% long position in our DJIA Timing System, and will only seek to pare back our long position once the stock market gets overbought again. Subscribers please stay tuned.
Henry To, CFA