Asia Is Key to the Burgeoning Bull Market

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (June 29th):

...If the markets have embarked on a new worldwide bull market the “new leaders” are likely to be emerging and frontier markets. That view was reinforced by our friends at the astute GaveKal organization, whose seminar I attended last Thursday. I love the GaveKal folks because they are truly “out of the box” thinkers; and, it is just such thinking that produces net-worth changing ideas.

Louis Gave opened the presentation by noting, “Things are feeling better because they are better; largely because of Asia.” With that, Louis turned the podium over to Arthur Kroeber, who is an expert on China/Asia, and author of Dragonomics, which is GaveKal’s sister publication. Arthur began by stating (as paraphrased by me so this will be generally correct and precisely wrong) that China’s economy has grown by roughly 10% per year for the past 30 years. A large portion of that growth has been driven by exports. Arthur made the point that export growth is really a “technology transfer,” as foreign companies share their knowhow (manufacturing, warehousing, distribution, etc.), allowing China to leapfrog up the learning curve much faster than it could have on its own. Clearly, such a technology transfer causes a huge improvement in labor productivity. More recently, however, the western world’s recessions have caused China’s export growth to slow.

To counteract this slowdown, the Chinese government has “thrown” a lot of money at the situation. Official figures show that in 2009 that stimulus was four trillion renminbi ($580 billion), but Arthur thinks the figure is closer to five trillion renminbi, or roughly 15% of GDP. This monetary stimulus should permit China to grow at 7% - 8% per year for the next couple of years. However, by 2011 the stimulus will be gone and probably not renewed. It is also doubtful exports will reassert themselves to former levels. Therefore, the government is working toward transitioning the economy from a story of labor productivity to one of capital productivity.

This transition was the MAJOR takeaway I got from GaveKal’s seminar. Manifestly, if accomplished, it would have extremely positive implications not only for China, but the rest of the world. Forcing reform in the financial markets is a major thrust of that transition. Accelerating reform in the financial markets should create more “efficiency of capital.” While the nascent reforms currently appear scattered, over time they should become more impactful, permitting capital productivity to replace the decline in labor productivity caused by diminished exports.

For signs this is beginning to work look for more IPOs, more bond issuance, large banks lending to smaller banks, and more diversified financial channels. As a sidebar, if this works, there should be a boom in Hong Kong real estate; but that is a topic for another time.

After Arthur’s conclusions, Charles Gave shared some very interesting stock / economic points, followed by Steven Vannelli (portfolio manager and head of U.S. research), who discussed why corporate/household balance sheets are not as bad as widely believed. As followers of our work know, we too believe balance sheets are not as bad as many fear.

However, the surprise of the session came when Louis Gave concluded the seminar with a “call” to consider investing in Japan. Hereto, followers of our work know we have eschewed Japan for decades due to fertility and demographic reasons. Yet, Louis’ reasoning was sound and insightful. To wit, while it’s true Japan’s demographics and corporate governance are terrible, a case can be made that Japan’s “freefall” is ending. It is also true that Japanese companies only restructure when there is a “gun” being held to their collective heads; and currently that “gun” is too much capacity. A quick perusal of corporate Japan shows the restructuring has already begun. Accordingly, the question then becomes, “Is this restructuring only going to foster another six- to nine-month rally in the Nikkei Index, or is this the start of a new bull market?”

As Louis opined, bull markets begin from cheap valuation. To be sure, Japan’s P/E mutliple is high, but think of it like a cyclical stock that you want to buy when the P/E multiple is high, and the price to book is low, like Japan is priced. Secondly, it takes excess liquidity to drive stock prices higher. In Japan’s case foreign investors, and commercial/central banks, are/should provide that liquidity. Indeed, Japan’s money multiplier is positive for the first time in two decades! Further, the Bank of Japan is engaged in quantitative easing, so liquidity should be ample. Thirdly, it appears with more detente between China and Taiwan there is also more integration between China and Japan.

Interestingly, Japan does more business with China than it does with the U.S. Thus, if China’s transformation toward “capital productivity” is successful, it could be hugely positive for Japan. Just think of the bull markets fostered by NAFTA (North American Free Trade Agreement) and the European Union (The Treaty of Maastricht). Finally, there are increasing signs the Democratic Party of Japan [DJP] is gaining traction over the long dominant Liberal Democratic Party [LDP], which could/should have positive ramifications for Japanese equities. Clearly, these views are “out of the box,” but as stated that is where net worth changing ideas begin. For further clarity we suggest contacting GaveKal.

As for our markets, we have not really changed that much since early May’s momentum peak at 930 on the S&P 500 (SPX/918.90). Since then, our indicators have flopped / chopped between positive and negative, indicative of a trendless stock market, which is why most of the indices we traded off of the March “lows” are no higher now than they were back in May.

Moreover, last Monday (6/22/09) was a 90% Downside Day (volume and points were skewed more than 90% to the downside). It was the second 90% Downside Day in the past two weeks and therefore counsels for caution. That said, we still think it’s a mistake to get too bearish. As Charles Gave stated in his presentation – this recession is an anomaly because productivity actually rose. That implies companies cut costs dramatically; and, if demand picks up it would suggest corporate profits could explode, causing one old Wall Street wag to exclaim, “Maybe that’s what the rally has been all about!”

The call for this week: We have now experienced two consecutive down weeks in the SPX, the first such occurrence since the March “lows.” Worryingly, both weeks contained a 90% Downside Day, which is why we remain cautious, but not bearish. Indeed, according to Bespoke Investment Group, July has historically been a strong month for equities, with an average gain of 1.17%, and a 70% positive monthly track record over the last 20 years. However, late last week the Russell Rebalance (Russell Investment Group rebalanced its 25 U.S. indices) created some “noise” that is unlikely to abate until quarter’s end. And speaking of noise, this morning we find out that even Greenpeace is against the Cap and Trade Bill as things remain curiouser and curiouser . . .

Comments

[Michael Clark]

Just noticed a comment by an official Chinese functionary (banking oversight committee I think) who said a full 50% of the Chinese stimulus was being funneled as low cost loans into the stock market in China and into real estate inflation, both of which are highly volatile and dangerous 'infrastructure' plays.

You can't believe what the Chinese say they are doing. Face is everything in Asian culture. No one will admit when things aren't going well. Death before dishonor.

2009 Jun 30 06:31 AM

[CautiousInvestor]

As of late much has been written about China's rebound in growth stemming from its stimulus efforts.

Electrical production recently increased 3.8% and industrial production is expected to increase 9.5% in May which will contribute to projected GDP growth of 7.6% in the second quarter.

More recently, though, there is growing concern that much, if not all of this improvement is a result of the stimulus and highly questionable lending practices. Exports are still shrinking from the collapse in international trade and the US consumer sobering up from his spending binge.

Taking this is to the case, the question must be asked what happens when the stimulus ends and exports remain in a coma? An add on question is what happens if this aggravated by massive loan losses from stimulus spending?

2009 Jun 30 06:37 AM

[Larry House]

Morgan Stanley's Stephen Roach says Asia will not provide the pulling power needed to help the world economy jump start. Our economic problems have been underestimated and dismissed as "we've been through this before." Not this time. It is never different until it is.

2009 Jun 30 11:41 AM

[Alphameister]

Ask not what China can do to pull the US and other western nations out of their morrass; ask rather what China and other asian nations can do for themselves and each other while awaiting the marginal benefits from stabilization and modest recoveries in developed countries. That's my perspective with my investments concentrated in Asia, and I've been very gratified to see China systematically acting to reduce its dependence on the US especially and developed markets generally. Thanks for another helpful commentary, Jeffrey.

2009 Jun 30 02:03 PM

[Michael Clark]

I'm living in Vietnam now -- my wife was born in Saigon. We are amazed how bombarded we are -- television, print, anecdotes -- with the corruption here. Businesses that are selling smoke and mirrors; running out on contracts. West Lake is an overdeveloped area for rich Vietnamese and Westerners living in Hanoi; we sat on the lakeside two nights ago and a friend of ours pointed out the luxury apartments and hotels on the far side of the lake and said: "They build all this for the Western tourists who were traveling and moving here four years ago. Now look at all the windows without lights. Those are enpty rooms." A good 70% of the windows were dark.

I don't believe that Vietnam and China are really that much different in this sense. Luxury hotels, gold courses and casinos for all the foreign travelers who were coming.....

2009 Jul 01 05:11 AM