China: 'Stir-Fry' Investing

Liquidity and confidence drives markets. Many point to leverage, low interest rates and high government spending as the source of America’s market boom and recent uptick. It is clear to me that the surge in Chinese markets this year is speculation largely due to the huge jump in bank lending and the lack of many viable investment options to put this money to work.

The Chinese refer to putting this cash into markets as “stir frying”.

The MSCI Emerging Markets index, for example (its ETF is EEM), trades at a price-to-earnings ratio of 16.1, which is 25 percent higher than its average P/E over the last five years. The Shanghai Composite in China recently hit a one-year high while the Hang Seng index in Hong Kong reached a level unseen since last October.

China’s hot market has overtaken Japan to become the world’s second biggest stock market by capitalization as investors pile into the fast-growing economy. China’s listed companies had a market capitalization of $3,210bn as of July 15 compared with Japan’s $3,200bn, according to Bloomberg data.

Investors have driven the Shanghai and Shenzhen markets up 75 percent and 95 percent respectively this year, thanks to the government’s $600bn stimulus plan, the effect of which was reflected in the hard to believe reported 8% percent second-quarter economic growth. The two Chinese stock markets are among the best performers globally this year though others in the region no doubt buoyed by Chinese growth such as Taiwan and Indonesia are not far behind.

The economic rebound has been driven by a powerful source of liquidity controlled by the ruling Communist party: a jump in lending by state-owned or controlled banks. Chinese banks, all but a handful of which are owned by the government, lent over a trillion dollars in the first half of this year, nearly double the total loans extended in the whole of 2008. As for June’s lending, at $220bn in new loans confirmed the trend as banks opened the spigots under the watchful eyes of the mandarins, just as they did in March (to $280bn).

This liquidity is fueling the Shanghai Stock Exchange, where daily volumes are currently three times the five-year average.

Some state-owned companies have set up separate divisions just to speculate and trade stocks. We have seen this cycle before. Keep in mind that the Shanghai composite was as low as 1,717 last November — a 70 percent drop from its peak in late 2007.

In the first half of the year, it is estimated that banks operating in China made about $1 trillion in new loans — an astounding figure considering that all of the 2008 bank loans totaled about $620 billion.

What about earnings? The 741 companies in the MSCI Emerging Markets index that reported results since the end of the first quarter posted an average earnings drop of 92 percent, trailing analysts’ estimates by 14 percent, according to Bloomberg data. That compares with a 46 percent profit slide for Europe and a 31 percent fall for the S&P 500, Bloomberg data show.

What about valuations? Are investors paying too much for growth? The MSCI emerging markets index trades at 15.6 times reported earnings, compared with just over 14 for the S&P 500, according to weekly data compiled by Bloomberg. When developing nations last commanded a premium, the 22-country benchmark sank 54 percent in the next year.

But there are some that feel that this premium is now justified with banks in Asia generally healthy compared to developed countries and the growth potential of emerging markets going forward. Using a peg ratio whereby a market’s price earnings ratio is divided by its growth rate, many emerging markets still look attractive.

Another opportunity may be investing in China’s H shares that trade in Hong Kong. Some estimate that they trade at about a 40% discount to the A shares for the same companies trading in Shanghai and Shenzhen. iShares FTSE/Xinhua China 25 Index (FXI) is a basket of 25 of these companies and is exhibiing solid momentum.

It’s hard to fight this kind of momentum but investors need to stay on top of these markets and manage the risk. Be wary of getting carried away with China’s and emerging market bull markets. The MSCI emerging-market index had 13 bull-market rallies of at least 20 percent and 12 bear-market declines of the same magnitude according to data compiled by Birinyi Associates. That compares with five bull markets and four bear markets for the S&P 500 during the same period.

Enjoy the sizzle but watch out for the burn. The sting may be in the tail. I am keeping my hand on the leveraged inverse ETF to FXI (FXP).

Comments

[Romeo Fayette:]

The 20 day MA for FXP will shed some dead weight as we progress through next week. It's streatched to the lower limit of all its technical indicators, so an upward revision to its MAs could be the trigger for a snap-back, as long as FXP doesn't drop precipitously between now & then to offset MA gains. I bought yesterday, and I might double down next week.
ST FXP is a technical play; it's Russian roulette to time the explosion of this fundemental asset bubble in China. LT a pure short of Chinese government debt should be the prevailing strategy since the private sector's shortcomings have been offloaded unto the government... kinda like here in the US!

Disclosure: Long FXP

Jul 24 01:26 PM

[AndrewBaker:]

Don't forget that the Chinese are big big gamblers: they will bet on two raindrops running down the window pain and which will hit bottom first. So, when their market is supported, it rises big time, and equally big time falls when the wrong raindrop wins.

Bet on emerging markets, China especially, but be prepared to get out fast when a reversal comes, which it lways does. These are not buy and hold markets; they are buy and hold until in profit, then take it off of the table, waiting for another good hand to buy back in.

Jul 24 02:11 PM

[doubleshortetf:]

Been to China over 30 times since 1998 while working for 3 multinationals. It's amusing to see "experts" who has not been to China or spent few days in the big Chinese cities recommending Chinese stocks... Wonder if they ever spent weeks at a time in gritty factory towns or poor interior areas...

Some sober facts:

1. China is a communist country ruled by 1 party with iron grip. Party bosses pick the politicians and many private company managements since many private companies are ex-SOE (communist state owned enterprises).
2. Corruption in China is rampant and one of the worst even down to lower ranking employees. Even factory canteen chef gets "envelopes" in scheme where he claims he received 10 bags of rice when only 8 bags are delivered.
3. There is almost no "law" since law itself is written to support the communist party or corrupt local communist bosses. Judges are appointed by the local communist boss and few if any understand law. Many judges got job thru "guanxi" or connection and of course bribes.
4. The Chinese banks in are BIG TROUBLE. E&Y got in heaps of trouble for discussing hidden bad and uncollectible debts. Local communist cadres dictate banks to lend to their pet projects and of course friends who bribe them not to mention COMPLETE lack of transparency.
5. No one except pea size brains trusts the communist government's statistics which are MANIPULATED.
6. Many of the listed companies numbers are COOKED. Auditors and their management can be bribed and extorted. It's beyond me how anyone would trust Chinese companies' financials unless audited by Big 4. And even Big 4s audited numbers are suspect since most Chinese companies carry multiple books including one for taxation and another for real book with slush funds.
7. Latest Chinese share and commodity appreciation have lot to do with communists pumping money to the economy by directing the banks to make loans. This kind of stimulus cannot go on.

Now is good time to buy FXP when all the investment gurus in unison are recommending Chinese stocks.

Jul 24 02:58 PM