China: Beware Bubble 2.0

Last week we reviewed the white hot Chinese stock market with a cautionary note. I wanted to return to it briefly because the situation is serious and deserving of much more attention.

Putting aside price charts of the Chinese equity market for now and turning to monetary measures, we can see something rather alarming happening. China’s M2 has enjoyed a constant rate of acceleration as shown in the chart below (in semi log scale). But in late 2008 the rate of acceleration suddenly increased dramatically:

This was a consequence of the massive stimulus plan put into motion by the Chinese government. They pumped unprecedented amounts of liquidity into their economy to offset the world-wide economic slowdown. There would be nothing singularly alarming about that since all central banks around the world, as well as governments in charge of fiscal policy, have orchestrated a collective burst of activity.

What is alarming is that the Chinese economy, stock market and especially real estate market are just now displaying bubble-like characteristics. The government controlled banking sector is a mystery wrapped in an enigma. No one can begin to fathom the amount of non-performing loans on the books. Unlike the US which went through a gut wrenching cleansing - thanks to the largess of the lobby-less taxpayer, the financial sector is once again back in fighting shape (privatized profits, public losses). China has yet to address their toxic assets

As we briefly touched on before, since last year’s low the Shanghai market has now appreciated more than 100%. Once again the stock market has enthralled the average person in China with thoughts of wealth and the possibility of making more in a month than what they earn in a year at their regular job. Speculation in the market is seen as not only a legitimate way to make money but a very lucrative one with low barriers to entry.

A sure sign of a bubble is extreme turnover. Recently, the total Chinese stock market turnover (in one day) reached $63 billion. That’s more than the combined total turnover of $58 billion in London, New York and Tokyo for the same day!

I know we’ve been having an especially humdrum summer (in volume) but also consider that within the $58 billion turnover are billions of dollars worth of Chinese shares and ETFs (traded on North American exchanges).

Morgan Stanley Asian economist, Andy Xie says in a recent research report: “The stock market is in a final frenzy again. The most ignorant retail investors are being sucked in by the rising momentum.”

Turning to the real estate market, there is more bad news. The two rock solid methods of real estate valuation: personal income to price ratio and rental yield to price ratios are beyond extreme.

Although the US per capita income is approximately seven times that of China’s urban per capita income, the price per square feet is almost equal. Rental yields on properties is negligible with most below inflation levels - meaning that the primary rationale for buyers is continued future price appreciation not future rents earned.

Like other bubbles, this will end very badly. That is for certain. What isn’t certain is when exactly the music will stop.

One clue may be the date that many in China are eyeing as the expiration date of a Chinese government underwritten put option: October 1st, 2009 - the 60th anniversary of the National Day of the People’s Republic of China. The general belief is that the government will do everything in its power to not ‘lose face’ before that date so as to not mar the celebration. Of course, whether this is true or not is irrelevant. All that matters is that enough believe it to be so.

The reason I spend so much time thinking and writing about the Chinese economy and financial markets is that they are now a significant part of the global landscape. The precarious nature of this fragile recovery is even more clear when we realize just how pivotal a role China plays. Unless the rest of the world can recover fast enough to back on its feet before China’s bubble bursts, this could get ugly.

You can play this with obvious Chinese ADR shares like Baidu (BIDU) which does a very good job of tracking the Shanghai Stock Exchange composite with an added beta boost. And you can also use Chinese ETFs and closed end funds like the iShares FTSE/Xinhua China 25 (FXI).

You can read more of Andy Xie’s analysis here.

Comments

[RiskReturnO...:]

Thanks for the warning ... I have a feeling that it will be a non-financial event that will mark the top of China market ... perhaps something in Xinjiang, Tibet, etc, ... , in the meantime, Aug and Sept should be the final parabolic rise to support a peaceful People's Congress in October ...

best strategy may be to take profits on key holdings like FXI and use some of the profit to buy upside call options to participate in the final move (with defined loss).

Aug 06 10:48 AM

[contracontr...:]

China shows some similarities to Japan in 1988. Selling it short now might prove too early,as the bubble might reach absurd proportions first,before it collapses in a few years.

Aug 06 11:14 AM

[littlescherzo:]

On your chart I do see the accelerated money supply between Nov 2008 and today, but I don't see the deceleration of money supply the year preceding Nov 2008. In fact, between Oct and Nov 2008 the M2 month-to-month growth was nearly 0.

I also do have to point out that the acceleration of money supply is obviously coming into a period of steady state (vis a vis deceleration or acceleration), as a result of hightened sense of potential inflation threat. Mind you, China will still be expecting negative (year-to-year) PPI and CPI for most of the Q3. Like elsewhere in the world, it's still deflation that is front and center the issue of the day.

Luckily it's certainty, not uncertainty, that would result from any government policy initiation. We were shocked and awed by the force and speed that the government flooded the market with money through bank lending since November 2008. Today, less noticed, but equally impressive, was the finesse the bank inspection authority (银监会） masterfully displayed in fine tuning the how much, to whom, for what of lending with awesome precision.

You do have a terrific point in that China is fighting an extremely difficult battle and it may not win --- that is how to turn on the housing market to give the economy a more sustainable lift beyond state investment led stimulus, and yet not to repeat the bubble 1.0. So far the government has managed to massage the housing market back to the record level for Q2, now it seems to enact the high-wire dance of fine tuning the demand to regulate the property price inflation.

By comparison to the Obama's government, the Chinese government has done a far more nuanced job with terrific speed. Knowing how the Chinese government choked off the housing market during the bubble 1.0, I have no doubt they have the capability to regulate the property price inflation --- the policy tools are still all there.

The issue remains how long China has to keep the level of liquidity in the system as the policy makers play with the housing market. And most economists seem to believe it's fighting an impossible battle --- you can't engineer both inflation and deflation at the same time.

But it's fascinating to watch it all unfold. 3Q will decide if China could soft land the housing market, and the timing of the 10/1 national day will be purely coincidental. How China would play this game is all set. Therefore those who hold interests in the Chinese stock market should just keep the seatbelt fastened and continue to enjoy the ride for a while.

Aug 06 12:46 PM

[Alphameister:]

The acceleration of money in China has surely been accompanied by a slowing of money velocity, just as it has in the US and other nations, leaving them the same challenge of easing back as money velocity gradually accelerates. In a world fighting deflation at every turn, I don't see inflation becoming a serious problem anytime soon.

BIDU has had a nice run, but at 64 times earnings still trades below the norm of the past five years and at a multiple arguably low relative to projected growth. I considered buying it earlier this year but found too many alternatives in the China markets trading at low single-digit multiples of earnings expected to rise at rates many times the earnings multiples (amazing GARP stocks).

Both BIDU and the Chinese markets generally look like they could endure a correction on the order of 5% to 10% without disrupting their long-term bullish patterns (though the charts currently suggest nothing nearly that serious).

Just because a stock or a market is up 100% in less than a year does not ipso facto imply a "bubble." That judgment necessitates a fundamental evaluation of both the starting and current price levels, which nobody among today's SA China bashers seems inclined to do.

If you want to look at what a bubble looks like just prior to bursting, check out some of my current 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 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.

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). It would be a shame to miss completely the investment opportunity of a lifetime!

Aug 06 02:27 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 noncollectable 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 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 lend. 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.

Disclosure - Accumulating FXP and initiated shorting BIDU at $336. Open order to short more BIDU at $358.

Aug 06 03:08 PM

[johnqh:]

doubleshortetf:

It seems that you like to copy and paste in a lot of Chinese threads. I would just like to point that out because I have seen your exact same post before.

Aug 06 07:36 PM

[HaavBline:]

None of what you said are new factors the will move markets. Right or wrong, those are 'known factors' for everyone who invest in Chinese markets. Have been that way before you first went to China in 1998.

In other words, they won't help your short position. You better watch out!


On Aug 06 03:08 PM doubleshortetf wrote:

> 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 noncollectable 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 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 lend. 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.
>
> Disclosure - Accumulating FXP and initiated shorting BIDU at $336.
> Open order to short more BIDU at $358.

Aug 07 12:24 AM

[HaavBline:]

"Like other bubbles, this will end very badly. That is for certain. What isn’t certain is when exactly the music will stop.

One clue may be the date that many in China are eyeing as the expiration date of a Chinese government underwritten put option: October 1st, 2009 - the 60th anniversary of the National Day of the People’s Republic of China. The general belief is that the government will do everything in its power to not ‘lose face’ before that date so as to not mar the celebration. Of course, whether this is true or not is irrelevant. All that matters is that enough believe it to be so."

This 'intelligent', 'politically astute' guess is a sure sign that the author hasn't invested in Chinese stocks for more than ONE year.

In late 2007 bull market, many 'investors' played the Chinese market based on the firmed believe that the Chinese goverment will support the bull market until the Beijing Olympics are over in Aug. 2008, supposedly the best date when 'the music will stop'.

But Chinese economy was overheating, commodities were sky rocketing. The Chinese goverment began to tighten in a big way, raising rates, shelfing projects, passing labor laws, forcing a market crash long before the Olympic dates arrive.

What's the lesson? The Chinese goverment does not manipulate the market as much as you might think. What they care most is the real economy.

Aug 07 12:34 AM

[rlirph:]

I for one agree with with doubleshortetf. There are too many "experts" here and else where who claim to be China experts but they have not spent sufficient time in the country. Many are confused with A shares, B shares, H shares.

I just like to point out the fact that China government is the biggest landlord in the country. In spite of all they say, please understand that land auctions bring in lots of money each year to the government coffers. The government may say and act half-heartedly about high real estate prices. In reality it is against their interests that real estate prices collapse or remain low. Just look at how Hong Kong government maintains high real estate prices and you will see how China government will act in the future.

US Expat Living In GZ...

On Aug 06 07:36 PM johnqh wrote:

> doubleshortetf:
>
> It seems that you like to copy and paste in a lot of Chinese threads.
> I would just like to point that out because I have seen your exact
> same post before.

Aug 07 01:14 AM

[Ben Gee:]

The question will be when China's bubble burst, how many people and how will China's economy be hurt? The bubble bursted in 2007-8, it did not seam to have hurt China too much. Will this time be different? The next question is will the Chinese government step in? When? It seams the Chinese government is taking the pulse of what is happening, will it step in on time? We are in new territory, if the Chinese economy collapse, there will not be anyone to pick up the pieces.

Aug 07 03:32 PM

[Tony Daltorio:]

Oops, sorry. When I read through your litany of "facts", I thought you were talking about the US economy, market and government.


On Aug 06 03:08 PM doubleshortetf wrote:

> 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 noncollectable 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 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 lend. 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.
>
> Disclosure - Accumulating FXP and initiated shorting BIDU at $336.
> Open order to short more BIDU at $358.

Aug 07 04:17 PM

[Tony Daltorio:]

I'd also like to point out that many "experts" like doubleshortetf have never been outside the big Eastern cities of China where US businesses are located. They have no clue what is going on in the other 90% of China.


On Aug 07 01:14 AM rlirph wrote:

> I for one agree with with doubleshortetf. There are too many "experts"
> here and else where who claim to be China experts but they have not
> spent sufficient time in the country. Many are confused with A shares,
> B shares, H shares.
>
> I just like to point out the fact that China government is the biggest
> landlord in the country. In spite of all they say, please understand
> that land auctions bring in lots of money each year to the government
> coffers. The government may say and act half-heartedly about high
> real estate prices. In reality it is against their interests that
> real estate prices collapse or remain low. Just look at how Hong
> Kong government maintains high real estate prices and you will see
> how China government will act in the future.
>
> US Expat Living In GZ...
>
> On Aug 06 07:36 PM johnqh wrote:

Aug 07 04:20 PM

[Tony Daltorio:]

What a funny article! I can't stop laughing - "the (US) financial sector is once again back in fighting shape." The author should get his kool-aid somewhere besides Wall Street and CNBC.

Aug 07 04:23 PM