How You Know the Chinese Market Is in Trouble

For the third time in under ten days, the Shanghai market has fallen based on fears the Chinese government might merely rein in profligate lending. Earnings have nothing to with it, this isn't an earnings scare. Nor is it some sort of economic data point which has shaken the market for the third time in ten days. Rather, it is simply the fear that the Chinese government might actually try stop bad loans from happening and help create a healthier financial system. Thus the market is falling on fears that the country might actually come to its senses when it comes to lending and the use of liquidity. Efforts to have a smarter economy hurt the market? That is a problem. It clearly exposes the market as supported by nothing but greater fool theory.

The Shanghai Composite Index lost 2.4 percent after the People’s Bank of China said it will fine-tune monetary policy where necessary and guide “appropriate” loan growth...

“The ‘fine-tune tone’ is spooking investors who are worried that the central bank will follow up with tightening measures, such as hiking the reserve ratio,” said Wang Zheng, a fund manager at Jingxi Investment Management Co. in Shanghai. “With the market at a high-flying level, investors are very sensitive to any news related to liquidity.”

Thus the market shakiness makes it is even more clear that this is not a market for sound investment, despite Goldman's (GS) recent strategy saying it is, and even as a punt the market is looking shaky as well. The chart below shows we are nowhere near to breaking the previous high, yet we have a jittery market already without valuation support. To me this says we've seen a bear market rally, and prudent money, if any is left in the market, should be heading for the exits. If you don't take my word for it, listen to Andy Xie and then decide.

Comments

[Alphameister:]

Worthless article that displays an ignorance as to the remarkable values still available among Chinese stocks. And where is the reference to your articles early this year advising investors of the buying opportunity of a lifetime in Chinese stocks. Oh, you didn't write them? Were you one of the "greater fools" who thought the Chinese market would just keep crashing despite a growing economy and slew of growth stocks trading under book value.

Aug 06 09:16 AM

[Vincent Fer...:]

Alphameister instead of actually arguing points, you simply blame me for not writing a china buy article early this year or explaining why the market as a whole is a "remarkable value". I've also seen from previous posts that you are long Chinese stocks. I'm not sure what you're trying to accomplish here with such comments. Best of luck.

Aug 06 09:38 AM

[Consider_this:]

Need more fear mongering articles like these.

As a contrarian, without people screaming "China stock will fail" and "the great china stock crash is coming" and "how the china govt will trigger the crash", *I* would be concerned and sell my holdings.

I did exactly that in 2007 and early 2008; when everyone and his mother no longer feared China and everyone wanted to ask me how to switch 401K to increase China exposure.

There's enough fear of China right now to trigger a healthy, strong "climb the wall of worry" rally. When the bears all turn greedy and jump onto the bandwagon, that's when it's time to get out.

Aug 06 09:52 AM

[Alphameister:]

Yes, I am long Chinese stocks. And I apologize for referring to your article as "worthless" in a fit of exasperation. Most of my negative comments in reply to articles such as yours have been along the lines of the above comment by Consider_this: "keep these negative articles coming so my Chinese stocks can continue to climb a Great Wall of Worry. "

I am no expert on China, but well over half my GARP investments these days are in Chinese companies, so I read virtually every Seeking Alpha post that comes along regarding China. I missed the previous bull and bubble in China because my initial investment in that country proved to be a fraud and that entire investment was lost. If anyone should be predisposed to be suspicious of the Chinese market, c'est moi!

My wariness of the Chinese market was ultimately overcome by my commitment to GARP investing ("Growth At a Reasonable Price") and my commitment to objectivity. For most of the past year, I've found relatively few GARP opportunities in the US markets, but a plethora of them in China. And when I consider the comparative health of the Chinese versus the US economies and the prospects of growth going forward, I ask myself why I should have ANY investments in the US.

When I was investing heavily in Chinese stocks early this year, I don't recall reading SA articles from today's self-professed China experts to the effect that the buying opportunity of a lifetime had arrived. The impression created is that they are now so chagrined about missing such an opportunity that they want to portray it as utter foolishness begging for punishment. The real excesses are to be found at the lows of late last year and early this year, not at today's highs (still 40% below the prior peak even though China has grown impressively in the interim).

My accounts are up more than 100% ytd and 150% from the lows, largely based on my holding/trading Chinese growth stocks. If you want to look at what a bubble looks like just prior to bursting, check out some of my Chinese holdings: ORS (less than 3 times earnings), CSR and CPHI (5 times), TPI and TSTC (8 P/E), XSEL and SUTR (6 P/E), HOGS (9 P/E). These multiples are all based on trailing 12-month earnings; using 2010 estimates the multiples are even lower. I also own a couple of stocks sporting "glamor" double-digit P/E's, though the multiples for ABAT and APWR both drop under 9 based on 2010 estimates. If I were more willing to hold OTCBB stocks, I could lower my average P/E considerably.

Nobody hates communism and socialism more than I do, but I see in China a country gravitating toward free-markets at the same time western nations are moving in the opposite direction. The idea that all or most numbers out of China are fiction seems to be simple-minded. I see China desiring to become a respectable world economic power and that can't be achieved through a gigantic fraud. As for the purely xenophobic comments on China, no need to address them.

If the audited numbers coming out of China are reasonably reliable and the country's growth prospects exceed those of the developed world by a factor or 3 or more, it is entirely possible that Chinese stocks will eventually trade at significant premiums to their US counterparts. I'm not counting on that, but it could provide a nice kicker that could add materially to the substantial additional gains I currently anticipate based on conservative fundamental analysis.

When any market has risen by more than 80% in such a short time frame, a handful of downdays amounting to a few percent should hardly be surprising and are a warning of collapse only to those for whom the wish of a collapse is father to the thought of a collapse.

It's not too late to hop on the Chinese investment train (though I became hedged this week for the short term based primarily on the heavy rate of insider selling in recent weeks).

Aug 06 12:17 PM

[Alan Young:]

The author is on target. The Shanghai stock market is booming on easy/fast money; this is a precarious rally. Whether or not the stocks have underlying value isn't even the point. There are a lot of new, inexperienced investors in China, and they will panic quickly when prices start dropping. That would be a good time to be short anything even near China, as panic tends to be contagious.

After that correction, I'll be a buyer again. Once you get past the noise in the market, there is a good growth story here.

Aug 06 12:40 PM

[Observer45:]

"Nobody hates communism and socialism more than I do, but I see in China a country gravitating toward free-markets at the same time western nations are moving in the opposite direction. The idea that all or most numbers out of China are fiction seems to be simple-minded. I see China desiring to become a respectable world economic power and that can't be achieved through a gigantic fraud. As for the purely xenophobic comments on China, no need to address them."

Well spoken! Often the Chinese authorities do not copy what is done in the west blindly, they take, adapt and apply what is suitable for their economy at this present stage of growth, economically and socially. A lot of people cannot see this much less accept it.

Aug 06 12:52 PM

[Vincent Fer...:]

I have been to China on multiple occasions both in a business and holiday setting and bear no ill will towards the country. I say nothing in my piece to accuse china of being too communist or that its numbers are suspect. I don't know where this is all coming from in terms of comments. Note I actually say that I believe the market is fearing a Chinese government which actually makes a better financial system by reigning-in lending. I hope the government reigns in lending for the sake of the country.

My piece is also not simply screaming that the market should come down just since it ran up so much this year. Note I link to a previous article of mine where I do a detailed rebuttal of the latest Goldman portfolio strategy, maybe skeptics of my piece should take a look at it. The chinese market looks stretched even by the measures of a stated bull, the Goldman strategy piece's author. By his own numbers it is shaky and he basically admits he's just hoping for the government to support the liquidity side of things. He admits there is basically little of a valuation argument left in favor of current levels. Finally note a veteran China hand, Andy Xie, is also linked to in my article, and also sees the market as over-priced and a dangerous bubble. I recommend anyone who is bullish go and read that piece as well. Could it keep running up based on people continuing to pour in. Sure. Great if you are able to capture further upside. But I think it's a very risky proposition, even as a punt. And should basically be completely ignored if your aim is to make an "investment" rather than a simple punt. Anyways, thanks for the back and forth.

Aug 06 02:42 PM

[Alphameister:]

My comments were intended to address a wide range of articles and comments recently appearing regarding the vulnerability of Chinese stocks. My real objection to your article was that its only "original" contribution was an observation of a few hiccups in a market that has had such a great run, hiccups based on a fear that Chinese authorities have sought to contradict. Otherwise, you reference the same comments referenced by a dozen other China doom-sayers in SA articles. I don't need "a veteran China hand" to tell me there are no good values left in the Chinese market when it is obvious to me, based on a long record of successful analysis, that the China market is filled with good values (which is why I invited your attention to some of them). Did that "veteran China hand" tell investors to buy Chinese stocks with both hands back in Jan-Mar? Certainly the values offered by China stocks today don't compare with those available earlier this year, but neither do they come close to qualifying as some bubble built on greater fools. Even if today's stock prices were facilitated by easy credit, that does not invalidate their fundamental appeal.

Aug 06 03:08 PM

[Vincent Fer...:]

If you don't see anything new, I think you missed the fact that this article was a continuation from my previous article which goes through a very recent Goldman piece and rebuts it in depth. researchreloaded.com/c...

Such an open and direct public rebuttal of Goldman's China market strategy view won't exist anywhere else on the net, and I use Goldman's own words to support my view.

Aug 06 03:35 PM

[YoYoMama:]

I would like to see the two of you take it outside...

It makes me uncomfortable how fast and furious the Chinese train is going. Eventually, the train comes in the station.

It's been a nice run, but now may not be the time to buy. I'm waiting for a pullback or bubble burst.

Aug 06 06:37 PM

[Ricard:]

Alphameister,

I remember you posted on one of my articles about small cap opportunities in China. I was afraid of going into non-ADR China stocks for precisely the reason you stated (shammed). I've been very fortunate to have stumbled upon some very solid and profitable ADRs in the past several years, and have stuck to that strategy. One of them, ACH, is up over 150% from my average buy price over last winter. My first play on this one was back in late 2005-2006, short term 3-month 2x bagger that I sold immediately. When I saw recently that the stock had skyrocketed to 3x my sell price, then plummeted to 1/2 my original buy price, I jumped again for one hellova ride.

Personally, I think enough remains an unknown about China for 'foreigners' like us that I'd stick to the stodgy names that already have more volatility than anything we see here in the states. ACH fell 90% over 6 months - *90%* - and this is their equivalent of Alcoa. Luckily, such volatility creates several entry points.

Regarding this article, I'd advise the author to look at the volatility in China stocks. He'd find that 10% moves on any ticker on any given day is par the course, and that it takes a slightly different outlook to invest in China than it does America. The great thing (to me) is that it punishes momentum investors like you wouldn't believe (resistance is futile, lol), and rewards fundamental investors with triple-digit gains.


On Aug 06 12:17 PM Alphameister wrote:

Aug 06 10:13 PM

[Vincent Fer...:]

I see what you are saying about volatility, but the point to me is not so much the magnitude of the recent falls, but more what the falls are coinciding with- the chinese government considering measures to stop potential bad lending. You have a market falling on good long term ideas for the chinese economy. And on the flip side, the market is supported by the belief that the government will continue with pretty irresponsible policies toward lending. For those who are just punting, this doesn't matter I guess, though it would still worry me, but what I am saying is that it is hogwash to call putting money in the chinese market "investing" right now. And this goes back to my criticism with the Goldman strategy piece mentioned in the article.

Aug 06 10:51 PM

[HaavBline:]

A liitle bit of warning from the goverment, a spread of fear among 'investors', a little correction on the market. To me this sequence of events display very normal and rational market reactions, not a bubble about to burst.

Barely months since their economy recovered and G7s are still mired in recession, the Chinese goverment is not about to really tighten liquidity, they are merely going to tighten the monitoring of lending abuses. The warnings is about keep greed in line while keeping economies humming.

The greater fools may be those who failed to catch the doubling of Chinese market 8 months ago and now too scared to step in and keep praying for a 'meaningful' correction. They may not even get one.

After some rest OR a 5-10% correction, the Chinese bull market will resume.

Aug 07 12:05 AM

[Ricard:]

Perhaps. I'm not sure whether your philosophy leans towards the fundamentals or the technicals, but I must say that the fundamentals for a good number of Chinese stocks are pretty decent. SOHU is trading at at 14 P/E with rising earnings for one...compare that to GOOG or BIDU. SOHU's PEG is also noticeably lower, so even though I share your concern about the rally getting long in the tooth, I still bought SOHU when it dipped below 60 recently. I still consider GOOG and AAPL to be wildly expensive in comparison.

Regardless, there's no reason not to be cautious - good luck with your trades.

On Aug 06 10:51 PM Vincent Fernando wrote:

Aug 07 12:28 AM

[Vincent Fer...:]

Ricard, sure good luck to you as well. But just note the bullish Goldman strat piece I took issue with itself even says that valuations quite high, even by the standards of the last few years. I'm saying there aren't any fundamentals to stand on anymore. Maybe there are technicals if that's how you buy stocks. But even technicals will matter little to me when its really just about what the government decides to do with their bubble. So the bull case is just to say you think the government will stay loose despite the fact that the longer they wait the worse the crash they are setting up. But if you are happy with buying on that, fine.

Aug 07 07:20 AM

[Ricard:]

LOL, I am about the closest you will find on SA to the polar opposite of a technical investor.

SOHU's fundamentals look good, but I've already hedged my bets on YGE and ACH. I've made triple-digit-gains on both of these, and see every reason to buy protection heading into this winter. I still see some correlation with China stocks and the US economy, and IMHO this winter looks to be particularly dreary for us.

Regarding your news, I'm not sure if it is substantial enough to warrant any action, and my comments about volatility were inferring that it is a non-event. Greenspan made his comment about 'irrational exuberance' back in 1996...4 YEARS before the 2000 crash. But, if you've had a good run, I'd also hedge at the first signs of the frost. Cheers.

On Aug 07 07:20 AM Vincent Fernando wrote:

Aug 07 04:22 PM