Is the China Craze a Tech Bubble 2.0?

The recent near vertical rise of iShares FTSE/Xinhua China 25 Index (FXI), the China ETF which tracks the FTSE Xinhua 25 index, reminded us of the price rise of the technology sector (the Tech SPDR (XLK) and the NASDAQ Composite) just before the tech bubble burst a few years ago in 2000.

We explored that question graphically with the chart below, in which we superimposed two different time periods, 1999-2002 for XLK and NASDAQ Composite over 2006 for FXI. The similarity in the price action is striking. [click to enlarge]

The red line is FXI in 2006. The green line is XLK in 1999-2002. The blue line is the NASDAQ Composite in 1999-2002
This overlay chart is hand traced over precise computer charts and is not as exact as a machine drawn chart, but is close enough for the points being made.

In each case, the "bubble" stock rose about 80% in 12-15 months. The XLK rose only 65% in a single year and took 15 months before reaching an 80% increase, while the FXI took only 12 months, a more rapid rise than XLK in the internet bubble period. Of course, there were specific tech companies that soared way beyond 80% before crashing.

The NASDAQ Composite, the official home of the internet bubble, had a price pattern similar to that of XLK.

Too much of a good thing is often a bad thing. It's true for candy, ice cream and turkey at Thanksgiving, and it is typically true for security price rate of change [ROC].

Here are precise comparative numbers:

Let's take a look at some technical measures for FXI:

There really isn't that much fundamental data to review about the portfolio of FXI, so we are left mostly to gauge macroeconomic trends and technical factors. The technical factors are not good, if you believe that very high ROC typically results in a reversal, and that reversals tend to continue until overdone.

For example, if FXI reverted to its 50-day simple moving average, it would decline a further 9%, and if it reverted to its 200-day average, it would decline a further 22%.

The 1-SD lower 20-day Bollinger band (a reasonable price swing target) is just above the 50-day moving average, 7% below the current market price of FXI.

We think the probability of more downside is greater than the probability of more upside in the short-term. However, anything, up or down, could happen with such a popular, hot money theme as China.

This doesn't mean that the China enthusiasm is based on thin fundamentals as was the internet bubble, but it does raise questions about the rate of change of China valuation and perhaps the level of valuation.

As the strong decline last week showed, there has either been a rethinking of valuation for emerging markets or profit taking deferred until after the last tax year.

The FXI gave a good head fake up before taking a dive down, as this five trading day chart shows. India (INP) and emerging markets generally (EEM) popped up a bit and took a dive also, but not as dramatically as China.

We are not calling a top or a crash, but we are nervous and wary of pattern similarities.

Our portfolio took a pretty good beating last week from the emerging markets. Last Friday we sold our positions in EEM and FXI (as well as a closed-end India fund) while we step back and re-evaluate

Disclosure: Authors owns none of the securities mentioned.

Comments

[PINAKi DASG...:]

China's rate of growth declining was more than expected in 2007.but how fast the bust will happen remains to be seen. India appears to have some potential on the real estate /retail segment, though it depends on how they exploit it.The charts do paint a depressing picture

2007 Jan 08 11:09 AM

[jim stanton:]

FXI also trades at a premium to the underlyiny securities--30+%

2007 Jan 08 11:20 AM

[QVM Group:]

I'm not so sure of that premium. ETFconnect.com shows a discount of about 4% on the fund. If the ETF concept is working properly the institutions should be arbitraging away the premiums and discounts by buying and redeeming sharres in kind. Even with a 4% discount, however, the arbitrage mechanism would be working imperfectly.

2007 Jan 08 12:59 PM

[Ally Kendall:]

That's just not right. The NAV for FXI is >106, while it is trading around 103 today. Please check your facts.

2007 Jan 11 11:01 AM

[QVM Group:]

And there is the problem with public data feeds. The data feed I read reported that number and it was disturbing. I am glad to hear that the data fee was wrong. ETFs are not supposed to deviate from NAV by so much.

2007 Jan 11 11:18 AM

[howon_noin ...:]

China will continue to implement a series of policies in 2007 to promote economic development so china will continue to expand.......
I will put more on China fund such as OBCHX.

2007 Jan 08 03:37 PM

[John Chan:]

isn't it a more direct route to bet on growth of China with CEF, which is a real A-share closed end fund, especially if you consider the PRC goverment policy to have more H shares go back to Shanghai/Shenzhen and listed as A-share

Just look at China Life shares in Shanghai yesterday.

FXI is a H-share fund, it doesn't have QFII quota and cannot invest in A-share which is listed either in Shanghai or Shenzhen.

2007 Jan 10 03:09 AM

[Ally Kendall:]

What is CEF, if not Central Fund of Canada?

2007 Jan 11 11:03 AM

[QVM Group:]

I speculate that he was referring the the closed-end fund (abbrev. CEF) with the symbol CAF (a China CEF). That's my best guess.

2007 Jan 11 11:16 AM

[QVM Group:]

John, that's a good question. Interesting thought. I really don't know the answer. I'll have to look into data sources to see if I can make a comparison on past data. On future data, I am not qualified at the moment to compare A-shares and H-shares future probabilties.

I did look at the Morgan Stanley CEF for China A-Shares (symbol CAF) for which Yahoo has data from September 26th of 2006 and compared in to FXI (tracks FTSE Xinhua 25) for the same period.

FXI rose 27.7%, while CAF rose 44.1%.

If those 3 months of past performance differences persist over longer periods, you would certainly be correct.

2007 Jan 10 10:39 AM

[QVM Group:]

John,

More to the point of my article, the 44.1% 3-mont return of CAF being much greater than the 3-month return of FXI, further amplifies my concern about a bubble patter forming around China based on ROC (rate of change) as an indicator of likely reversals. It's just too much too fast -- a rate of change that is not sustainable.

Without even compounding that rate is over 170% growth per year. I don't think that the fundamental value of China under the most optimistic of assumptions can increase at that rate for long.

In one year $1 invested would grow to $2.70 and after the second year would be about $3.90 by the end of the second year (nearly quadruple in the original investment in 4 years). Could happen, but not likely and probabilities are what drive my decisions. I think the probability of a reduction in the rate of change is extremely high and the probability of a significant reversal of some of the recent gains is high.

2007 Jan 10 10:59 AM

[Ally Kendall:]

If you look at the P/Es of the SSEC A shares, they are far lower than the S&P 500. The Chinese stock market is the worlds largest Ponzi scheme, and it will continue to grow and gain momentum, with the occasional volatility spurt in one direction or another, for generations, as 1.3 billion investors pour their money into the hottest thing going. Shanghai and Shenzhen are nowhere near the point where they have sopped up the liquidity that is trying to find its way into those markets.

2007 Jan 11 11:37 AM

[QVM Group:]

Possibly a good analogy to a Ponzi scheme. Bubbles and Ponzi schemes have a lot in common, including their ultimate collapse. It's just a matter of when. You may be right that the supply of eager money is still quite deep and the the party will rage on before the dawn and the hang-over.

2007 Jan 11 02:50 PM