Keeping Track of China
(January 17, 2010)
Dear Subscribers and Readers,
As we've mentioned several times over the last few months, subscribers should keep an eye on China as it has been the greatest contributor to global economic growth and aggregate demand over the last 18 months. Its stock market has also led the U.S. and other major global equity markets over the last two years. More importantly, the Chinese market remains very opaque and inefficient (in terms of both alpha opportunities and capital allocation) – suggesting that any information that could be gleaned is much more valuable than what you read on sell-side reports or even independent research reports on the U.S. and other developed countries. In last week's commentary (“Identifying Short and Long Term Trends for 2010 – Part II”), we covered the immense capital spending in China last year (which we deemed was necessary and smart in light of the lack of aggregate demand growth and deflation in input prices last year). We also concluded that China's prospects look bright for at least the first quarter, if not the first half of 2010. In this commentary, we will update our views on China in light of the most recent December loan/credit growth numbers just released last week.
Before we dig deeper into the recent monetary/economic trends in China, let us review our 9 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 1,562.35 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 1,253.35 points as of Friday at the close.
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.
As we mentioned in last week's commentary – amid all the bearish talk of a bubble in China (and its imminent bust this year) – there are those who remain bullish on China, including Warren Buffett, Jim Rogers, GaveKal, and Goldman Sachs. Buffett, in particular, mentioned (during our visit to Omaha the Friday before last) that he is not concerned about the short-term market gyrations, as he believes that many emerging market countries (such as China) are now starting to implement systems that would allow its citizens to reach full economic potential over the next couple of decades. With a GDP per capita of only US$3,000, China still has a long way to go – especially if Schumpeterian growth starts to take off in the U.S. and other developed countries (this author believes the U.S. will spearhead the next wave of Schumpeterian growth yet again – most probably in the 2012-13 timeframe as technologies such as cellulosic ethanol, solar power, stem cell treatments, customized medicines (by 2013, the cost of sequencing a genome should be below $2,000, versus over $1 billion just ten years ago) come of age and as the U.S. accelerates/finishes its implementation of a next generation 4G/fiber optic communication network).
The most important take-away – and one which I have mentioned many times since we began seriously writing in 2004 – is that major peaks in any asset class or country is inherently difficult to call or trade against. It is not a conjecture or some kind of empirical observation (although empirical observation certainly backs this up) – but it is based on logic and is almost an axiom. By definition, there can only be one point in time (as represented by a trading day and at most a couple of trading weeks, although they do not need to be consecutive) when the market peaks. Coming off a (typically) long bull market, that means one is making a very low-probability bet. For example, there are about 252 trading days in a year. Even if you know that the Chinese real estate or stock market will make a major peak sometime in 2010, the odds of one calling and catching the peak is 0.4% (if one calls it to the day), and 4% if one manages to catch any point in time during the two trading weeks that encompass the peak. Since the market typically makes a parabolic move towards the end of a bull market, anything outside the two-week timeframe is impractical from a trading/money-making standpoint.
In addition, calling the top of a bull market and making a bet against it doesn't mean that one has the staying power to take advantage of the full downdraft. Plenty of bears who shorted great bull markets at the peak – such as Jesse Livermore – covered or reversed their positions prematurely, much to their detriment. Some bears even overstayed, as many hedge fund managers have found out to their dismay over the last ten months. Finally, a major bull market only dies of exhaustion – which means that at the top of the market, all the investable capital is sucked up by said market and almost every major bear would have covered their short positions (such as Julian Robertson's Tiger Fund in March 2000) before the market can go down.
Despite all the credit growth, the unprecedented surge in capital spending (what Pivot Capital terms the “capital spending bubble”), and the craziness in Tier 1 real estate, I still do not see an impending top in the Chinese equity market or the Chinese economy. I still stand by what I stated in last week's commentary:
On a macro basis, I expect the momentum in Chinese economic growth (and any secondary and multiplier effects on commodities, etc.) to continue through 1Q 2010, if not 2Q 2010. With much of its transportation infrastructure and manufacturing capacity now pushing its natural limits, I expect profit margins in many of these industries to be slashed in the second half of 2010 and 2011. Combined with higher-than-average commodity inventories, I expect commodity prices to make a major peak sometime in 2Q 2010 or the second half of 2010. For now, I merely expect a slowdown in Chinese economic growth in 2H 2010 and 2011 – not a major dislocation. This should also benefit the U.S. Dollar Index, and indirectly, U.S. consumer discretionary spending in 2H 2010 as the U.S. Dollar strengthens and commodity prices and Chinese wages decline.
From a sentiment standpoint, there are still too many investors looking for the “Chinese bubble” to pop, including some business school students that I met during the Buffett trip (in general, business school students as a group are good contrarian indicators). Moreover, as I mentioned in last week's commentary, valuations remain decent, as the forward P/E ratios of the MSCI China and CSI300 are just under 15 and 20, respectively (compared to 24 and 37 in late 2007, respectively). More importantly, while many bears are complaining about overcapacity in the steel and cements sectors, as well as a bloated highway/paved roads infrastructure, subscribers should note that capacity utilization in general (e.g. aluminum, oil refining, and railroads) is still trending up, as shown in the following exhibit courtesy of Goldman Sachs:
The above exhibit suggests that overcapacity in China is not a problem (although it may become a problem later this year or next year). Furthermore, while Chinese capital spending in certain sectors (i.e. steel, cement, and paved roads) may be losing its efficacy, subscribers should also note that a modern highway infrastructure is key to long-term success/economic growth in China. Criticizing China for having too many miles of paved roads and highways is not only counter-intuitive, but sloppy logic as U.S. economic growth in the 1950s and 1960s was hugely dependent on the federal highway infrastructure that Eisenhower advocated throughout his life (culminating in the Federal-Aid Highway Act of 1956).
As for growth in the Chinese money supply (M2) and credit – while the year-over-year growth rates continue to be astronomical – the quarterly annualized rates have come down dramatically, suggesting that: 1) The People's Bank of China is indeed having some success in tightening monetary policy, and 2) current monetary/credit growth is not as “red hot” as it was earlier in 2009 (following exhibits again courtesy of Goldman Sachs):
That said, the effects of the explosion in both monetary and credit growth earlier last year will linger on for at least the first half of 2010. Because of this, I anticipate the People's Bank of China to take an active stance in curbing monetary and credit growth, especially since capacity utilization is no longer a problem. With the recent bounce in commodity prices, inflation in China may surprise on the upside unless the People's Bank of China adopt a more aggressive stance in tightening monetary policy. As long as such moves are well communicated, I do not see an imminent decline in the Chinese equity market, especially given the decent valuations in China and a recovering global export market (note that China is also moving up the “value chain,” and has just displaced Germany as the world's number one exporter). Note that China could also try to curb inflation by revaluing the Renminbi on the upside.
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 January 2007 to the present:
For the week ending January 15, 2010, the Dow Industrials declined 8.54 points, while the Dow Transports declined 41.47 points. Since making new bull market highs just over a week ago, both indices have pulled back. This is a healthy development, and is what we have been expecting for many weeks. With the U.S. stock market still in an overbought condition, I maintain that we will be mired in a consolidation phase for the rest of January (especially given the ongoing concerns over the economies of Spain, Greece, and Dubai). However, given the strong momentum from the early March 2009 lows – and combined with decent valuations, strong liquidity, and strong upside breadth – there is no question that the cyclical bull market is intact. In the meantime, we maintain our 100% long position in our DJIA Timing System.
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 a reading of 17.7% to 19.4% for the week ending January 15, 2010. 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:
The four-week MA of the combined Bulls-Bears% Differential ratio just hit a new 26-month high and remains very overbought (not just relative to its readings over the last two years, but over the last decade as well). In addition, its relentless rise from early March suggests that individual investors have gotten too bullish, too quickly. That said, the actual evidence (e.g. the lack of equity mutual fund inflows) says otherwise. That is, while investors have started to get more bullish on the stock market, they actually have not put their money to work just yet. Given the amount of cash on the sidelines, strong liquidity, and decent valuations, there is enough "pent-up demand" for a decent rally in 2010, but probability suggests that the stock market is still mired in a consolidation phase that should last until the end of January. For now, we will remain 100% long in our DJIA Timing System, as we believe the cyclical bull trend that began in early March 2009 remains intact.
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:
For the week ending January 15, 2010, the 20 DMA rose from 132.8 to 135.0, after hitting a fresh 6-month high of 137.6 on December 1st. As mentioned on the above chart, the 20 DMA is now trading at the high-end of its recent range, and remains overbought relative to its readings over the last two years. Combined with the overbought readings in our other sentiment indicators, probability suggests that the market will consolidate further until at least the end of January. In addition, the macroeconomic backdrop - specifically the ongoing troubles of Spain, Greece, and Dubai the European banking system, as well as the US commercial real estate market - is also suggestive of a further consolidation period for the stock market.
Conclusion: Since the Chinese economy was liberalized in the late 1970s, the “social contract” between the Chinese government and its population has held and has allowed a significant portion of its population to expand their productive capacity – whether it is through state-funded education, infrastructure investments, the provision of a stable political/financial system, or gradually allowing information flow to and within the country. No doubt the progress on the political front will be very slow, but this does not mean that Chinese productivity cannot continue to grow for the foreseeable future. As long as workers are content with the current “social contract,” China's economic prospects remain bright, especially given the government's emphasis on long-term economic growth and a more cohesive society. While there is certainly some excess capacity in certain sectors, overall capacity utilization has been trending up – suggesting that China's capital spending plans in 2009 was not only logical, but wise. In addition, China has been tightening monetary policy in order to contain inflationary pressures. At some point later in 2010, there's a good chance the Chinese government will revalue the Renminbi on the upside in order to contain inflation. Unless the Chinese equity market goes parabolic from current levels, we are still not looking for a major peak in either the Chinese equity market or the Chinese economy. We are, however, looking for a slowdown in the Chinese economy in 2H 2010, and possibly well into 2011 if economic growth in the rest of the world does not pick up by then. This will have a bearish impact on commodity prices sometime in 2Q 2010, or 2H 2010. Sometime in the 2012 to 2013 timeframe, I expect U.S. (and the rest of the developed world's) economic growth to accelerate again – once U.S. households have paid down a significant portion of their debts and as the next generation of energy, biotech, and nanotech comes online that will drive the next secular bull market in US stocks and Schumpeterian growth.
As for the US stock market, our short-term belief is that the US stock market will be mired in a consolidation phase into at least the end of January. Should the US stock market experience a correction, there will be significant support at the DJIA 9,750 level. However, we remain bearish on the retail industry (as discussed in our commentary over a month ago), as well as the major US casino operators. Subscribers please stay tuned.
Henry To, CFA