China's Bull Market: Massive Underlying Risk Still Exists

The best bull argument I can find in regards to the Chinese market is that the government has little choice but to keep liquidity flowing, even if they know this will be negative in the long-term.

Since a government "investigation" can't possibly yield much, and since they're saying flat-out that lending won't be capped, this sounds incredibly bullish. China isn't going to take away the punchbown -- as we've noted, they just can't. When even the slightest hint of lending curbs recently brought up, the market tanked nearly 7%. Imagine if the threats were real. The bubble must roll on.

The government may fear the potential repercussions of deflating asset prices in the short term so much that they are willing to ignore the longer term consequences of fueling asset prices further. Fair enough, sounds like standard human nature when it comes to politics and just today Chinese officials have said they will investigate price gains but won't cap new lending. Thus if you openly regard this as a punt on the government's actions, fair enough we can't argue that. But...

We can warn that there is massive risk in such a punt and little edge one can bring to the table unless you have your own fly on the wall in Beijing. Where we take issue is if you say that this market is supported by fundamental value at current levels, or that buying is an "investment". Even the bullish Goldman (GS) strategy piece we confronted said valuations were high, but just hoped for more liquidity to keep coming (greater fool theory). An old China hand sees valuations stretched as well. The problem we see with the bull case is that it's underlying support could turn on a dime based on government whim and collapse in an instant.

All Chinese market bulls at these levels are punters, whether they know it or not. And we hope it works out for them.

Comments

[Alphameister:]

This China bull is holding a diverse collection of growth stocks priced at 3 to 12 times earnings, expecting some short-term weakness, and convinced that your certainty about excessive valuations is based on ignorance of the details underlying those 100% gains from the lows (gains that inherently invite talk of "bubbles"). But as long as you "hope it works out" for me (even if that makes your analysis questionable), I forgive you for not performing more in-depth analysis of the values behind those 100% gains.

Aug 09 11:59 AM

[Paul H. M.:]

It's funny, China bulls don't seem to realize that China is creating 10x as much fiat currency as the United States.

If you think our bubble was bad, just wait until this communist bubble hits the fan.

Wise money is still in the most transparent regions: Western Europe and the United States.

Putting you money in China is like playing Roulette, just place your bet and hope for the best.

And even if Chinese companies reap great profits, they will not let American investors see any of that, because they are all government ran and all the corrupt officials need to be payed off.

Aug 09 09:27 PM

[dybydx:]

Paul H,

ya putting money in PRC is like roulette. most big firms there are gov controlled.

although that also mean another thing, practically every bank/large firm is too-big-to-fail and you know they will never let firms like Bank of China (not the Central Bank of China) or SINOPEC or China Mobile to declare bankruptcy.

in the 90's the state was practically force feeding the banks with cash when they had to digest bad loans from non-performing state mandated programs.

i dont think their fundamentals make much sense, but if u like buying TBTF companies, i recommend Bank of China over Citi. cause when PRC bails you out, u dont get ur shares wiped out.

Aug 09 09:58 PM

[PairsTrader:]

The following is a summary from a blog post dated 4/12/09 by Ms. Dian Chu, which I thought would be an appropriate comment to this article. Ms. Chu is an oil industry economist, who is also a contributor at Seeking Alpha:

URL: dianchu.blogspot.com/2...

"Measures taken by Beijing in the midst of the worst and most synchronized global recession in our life time, such as infrastrucure-focused stimulus programs, flurry of new Free Trade Agreements (FTA's) among Asian countries, are in sharp contrast to the US reacting with protectionism and interfering with private companies operation.

It seems this unprecedented global financial crisis is nudging the US towards much despised centralized economy, while China is becoming more capitalistic. Though there's an ongoing debate about the two systems, at the moment, China appears to be acting more logical and rational."

Aug 09 10:02 PM

[Dian L. Chu:]

Indeed, in contrast to this ideological conviction of the West that markets knew best, virtually all Asian countries seem to believe that government has an important role in managing the economy. This is essentially the philosophy of Dr. Amartya Kumar Sen, the Nobel prize-winning economist and a Harvard professor, that the invisible hand of the marketplace has to be balanced by an emphasis on the visible hand of good governance.

This decoupling could lead to some major changes. For example, the Asian economies could perform better than their western counterparts for a good while, by adhering to western ideas on economic development as west effectively backtrack from them.

In addition, while many western populations are becoming increasingly wary of globalization, there is virtually no evidence of this in Asian societies. So, we might witness the globalization reversing direction from the east to the west. Only time will tell.
Thank you for referencing one of my older blogs. Your readership is greatly appreciated.

On Aug 09 10:02 PM PairsTrader wrote:

> The following is a summary from a blog post dated 4/12/09 by Ms.
> Dian Chu, which I thought would be an appropriate comment to this
> article. Ms. Chu is an oil industry economist, who is also a contributor
> at Seeking Alpha:
>
> URL: dianchu.blogspot.com/2...
>
>
> "Measures taken by Beijing in the midst of the worst and most synchronized
> global recession in our life time, such as infrastrucure-focused
> stimulus programs, flurry of new Free Trade Agreements (FTA's) among
> Asian countries, are in sharp contrast to the US reacting with protectionism
> and interfering with private companies operation.
>
> It seems this unprecedented global financial crisis is nudging the
> US towards much despised centralized economy, while China is becoming
> more capitalistic. Though there's an ongoing debate about the two
> systems, at the moment, China appears to be acting more logical and
> rational."

Aug 09 10:14 PM

[Joe Shareho...:]

China is trapped into buying our treasuries. Plain and simple. If they stop, the US economy won't be able to raise enough money to keep funding our existing debt, not to mention new debt in the form of bailouts, TARP, stimulus bills, nationalized health care, etc. If this happens, the US will have to print money, and the Chinese will see every treasury bill up to this point pressured by inflation.

China is stuck. However, we have to be careful also. If China doesn't agree with our monetary policy moving forward, we could be looking at a raging international red communist empire coming after us. This will most likely happen anyway eventually, as i doubt we'll be able to pay back our treasury obligations without just printing money and ruining the dollar.

Aug 09 11:23 PM

[Michael Clark:]

Fundamentals, in China? -- where every Chinese business has 3 sets of books: one for the tax people (showing small profits), a second for the bank (to show steady profits), and a third for management (to show the company met its targets) -- Chinese companies always 'meet their targets'. Which of the three accounting ledgers are we taking our fundamentals from?

Aug 10 01:29 AM

[batty:]

History shows that revolutions occur in the summer and during recessions US and France 200 years ago, Iran this summer. Berlin Wall and Tianemen square during the 88-89 recession. China will keep asset prices high to get through the summer. Watch out in October.

Aug 10 01:32 AM

[Michael Clark:]

It is not just America that is collapsing. The global economy that America insisted on is collapsing. This won't affect China?

As we head into a protracted depression, protectionism will take over; and then all bets are off. Protectionism will change the shape of world alliances and inaugurate a period of national survival. Growth rates of corporations will be replaced by schemes to ensure national and coalition self-sufficiency. The world will divide into two forces again, 'us' (every nation will become the proverbial 'us') against 'them'.

Aug 10 01:57 AM

[Ricard:]

After your repeated attempts to insist I read the GS piece, I finally read it (at least your article on it). It took me a while because I am comfortably invested in China stocks with a PEG of less than one, or P/E in the low teens - I had a difficult time believing there was something wrong with the fundamentals for the stocks I was holding.

My guess is that the small-cap in China stocks must have really taken off (or earnings have really hit a short term low), and there may be a flight to quality in the near future. Even the GS piece admits to there being quality about, one just has to find it.

One other thing to remember is that in times of difficulty, the P/E number will be high, even if price drops substantially. Earnings may have hit roadblocks; some companies, say, export-related, may have reported negative earnings, which may raise the number substantially for an index as a whole. The numbers in the GS report are too generalized to apply it to individual stock picking.

That was what I was implying in my comments on your last article - SOHU is a defensive play, 14 P/E (a quarter of BIDU), and still growing earnings (PEG < 1). There are still some plays out there that warrant attention - perhaps they are in the more stodgy names out of the bunch.

Regardless, I have hedged my core holdings in China. I think the main focus on the GS piece was short-term hedging and buying on dips, even though by any measure the valuation numbers they quote are lofty - what the fundamentals they presented did not delve into are growth projections, and for emerging markets, growth is a fundamental aspect of the equation.

Finally, regarding your points about government policy, I believe their government has fewer issues than ours in getting economic policy straightened out this time around. I find it to be a relative plus.

Aug 10 01:58 AM

[Vincent Fer...:]

Keep in mind while some Chinese companies may be "too big to fail", it doesn't meant that shareholders can't get wiped out. Thing of Citi or AIG in the US.

I also wouldn't go beating the government knows best drum too much Dian Chu, though thanks for the comment. Free market forces are what brought China up, once they were allowed to increasingly flow through the country. If anything China is a lesson in how important freeing an economy from government meddling can be. China still has tons of meddling, but luckily an industrious population is build the country from the ground up. I recommend you read China Dream by Joe Studwell for great detailed descriptions of how your ordinary chinese built todays stellar growth once they were freed to do so, while government merely took the credit for "directing them to do so". The average chinese man with the freedom to make economic decisions is what is making China powerful while the government is taking the credit.

Aug 10 01:58 AM

[Ricard:]

I respect your opinion, but I hope for everyone's sake that you are dead wrong on this one.


On Aug 10 01:57 AM Michael Clark wrote:

> It is not just America that is collapsing. The global economy that
> America insisted on is collapsing. This won't affect China?
>
> As we head into a protracted depression, protectionism will take
> over; and then all bets are off. Protectionism will change the shape
> of world alliances and inaugurate a period of national survival.
> Growth rates of corporations will be replaced by schemes to ensure
> national and coalition self-sufficiency. The world will divide into
> two forces again, 'us' (every nation will become the proverbial 'us')
> against 'them'.

Aug 10 02:00 AM

[Ricard:]

Wrong country. You're referring to American business here, with earnings after dilution for the tax people, operating earnings for banks, and pro forma earnings for management. Where's the bottom line again?

On Aug 10 01:29 AM Michael Clark wrote:

> Fundamentals, in China? -- where every Chinese business has 3 sets
> of books: one for the tax people (showing small profits), a second
> for the bank (to show steady profits), and a third for management
> (to show the company met its targets) -- Chinese companies always
> 'meet their targets'. Which of the three accounting ledgers are
> we taking our fundamentals from?

Aug 10 02:03 AM

[Sober Realist:]

I agree with you on this one. Globalization will be thought of as anathema by the decimated American middle class. Read my article on this:
"The Wealth Gap and the Collapse of the U.S."
seekingalpha.com/user/...


On Aug 10 01:57 AM Michael Clark wrote:

> It is not just America that is collapsing. The global economy that
> America insisted on is collapsing. This won't affect China?
>
> As we head into a protracted depression, protectionism will take
> over; and then all bets are off. Protectionism will change the shape
> of world alliances and inaugurate a period of national survival.
> Growth rates of corporations will be replaced by schemes to ensure
> national and coalition self-sufficiency. The world will divide into
> two forces again, 'us' (every nation will become the proverbial 'us')
> against 'them'.

Aug 10 02:07 AM

[expat in China:]

I have witnessed the rush to get on the sinking boat (China Markets) over the last 5 years by average middle and low income families and like every country the money traders transfered the wealth in 2008. Will it happen again any time soon, its a casino royal pure and simple.

This is definitely true from Michael Clark stated!
"Fundamentals, in China? -- where every Chinese business has 3 sets of books" and you can add the 4th set of projection to sucker in the investment community same as any investment firm does.

I don't believe for a minute that China is trapped into financing the USA debt, they have been missing or buying shorter in the past 3 months at any auctions. They will dump the dollar when they feel it is time and they do not want to start a war over it. "Slowly we rotate commodity by commodity until we balanced the inflation risk"

China is the #1 protectionist regime in the world so they can nationalize anything anytime and default on bond holders or dividend payments.

Aug 10 04:00 AM

[manya05:]

Indeed, the American middle class has never been too keen on globalization. Getting even heavily stunted free trade agreements through Congress is a tough sled. Once the American middle class is decimated by globalization, and the standard of living of the working stiff becomes demonstrably lower as a result of these policies, there will be a big rush towards protectionism and isolationism. These have always been part of the DNA of America as a nation...just slightly suppressed in the post-Nixon era to enrich the few on the backs of the Chinese poor...(read, the American oligarchy in cahoots with the Chinese communist apparatchiks).

Aug 10 05:12 AM

[ArtfulDodger:]

Bubbles, bubbles, bubbles everywhere! This has become the most popular word in the investing world.

When something becomes that ubiquitous, it's usually worthless to an investor.

Aug 10 12:45 PM

[Tony Daltorio:]

Sorry, I was confused for a moment by your comment - I thought you were talking about companies involved in the epicenter of the financial earthquake - US companies. Sure sounded like it......


On Aug 10 01:29 AM Michael Clark wrote:

> Fundamentals, in China? -- where every Chinese business has 3 sets
> of books: one for the tax people (showing small profits), a second
> for the bank (to show steady profits), and a third for management
> (to show the company met its targets) -- Chinese companies always
> 'meet their targets'. Which of the three accounting ledgers are we
> taking our fundamentals from?

Aug 10 01:49 PM

[jjp:]

Canary in a Coal Mine.
One Chinese stock that has taken off like a rocket is FUQI. They make gold, silver, and diamond jewelry. The Chinese are not going crazy buying party accessories. They want to change their Yuan into gold, silver, and diamonds. I am getting out of my other two stocks and holding on this one since if it hits the fan, this one may continue up.
As for other stocks, even if the fundamentals are great, just as a rising tide lifts all ships, when the opposite happens, they all end up sitting on the mud flats.

Aug 10 04:10 PM

[Reactionary:]

"If anything China is a lesson in how important freeing an economy from government meddling can be. China still has tons of meddling, but luckily an industrious population is build the country from the ground up."

Nice story about those hard working, industrious Chinese, but it's only part of the true picture. Let's not forget that the govt. has been manipulating their currency for years to artificially boost exports and thus destroy productive capacity in "trading partners" while simultaneously erecting a very real trade barrier. Consumer goods produced in prison factories full of political dissidenters is another government sponsored productivity booster (no doubt being eyed enviously by the current administration in the US). Shameless piracy of intellectual property, from copyrighted protected music/video to patented designs, is typical of the Chinese approach and a window into their culture of theft. Also, let's keep in mind the unfathomable sums of Western investment in terms of both cash and human expertise that have built the modern production capability of China. That investment was brought in using the lure of the worlds biggest consumer market. The price was huge dollars, forced partnering with Chinese companies, aid to the government in monitoring information and suppressing dissent, and technology give-aways. Western companies are being plundered in exchange for promises (probably false) that they'll reap long term rewards from their access. But as expat in China said above, "China is the #1 protectionist regime in the world so they can nationalize anything anytime and default on bond holders or dividend payments. "

Aug 28 08:34 AM