China: Too Much, Too Fast

The Chinese economy is overheated and China, the stock market phenomenon, is overheated too.

The Chinese government is taking steps to restrain growth. Wall Street analysts have begun to take steps to warn investors of overbought conditions for Chinese stocks, saying China is significantly more expensive than other Asian markets. What more signal could an investor want to reduce exposure to, or at least tighten stops, on Chinese stocks?

The 13-weeks Rate of Change [ROC] chart below supports the fundamental arguments. It shows the U.S. (SPY) staying within a range of +/- 10% ROC, and shows emerging markets (EEM) staying within a range of +/- 20% ROC. However, China (FXI) has recently broken out of the emerging markets range and has pierced +30% ROC. Even after a bit of a stall, FXI remains well above the +20 ROC emerging markets range.

Discretion may be the better part of valor here, as Shakespeare might have said.

[click to enlarge]

Comments

[Chris Thomas]

China's stock market is clearly overvalued. As of 2005 no one would have touched their exchanges, due to the immaturity of their financial system, the lack of the rule of law, and the fact that the state dominates many of its companies (CNOOC, a darling of Shanghai, is 70% owned by the government). So as an investor, it's important to ask "what changed in 2006?". Certainly, there have been small improvements, but obsolutely not enough to propel the market forward 130%. There will be a crash - the question is not if but when. However, I would not go about shorting these stocks, as tempting as it may be. As the saying goes, markets can stay irrational longer than you can stay solvent. Some of the largest fortunes were lost attempting to short the tech bubble. Right trade, wrong time. Personally, I'd wait until the crash and then go bottom fishing, because China's economic growth still is remarkable and will continue for many years to come.

On that note, I disagree with the assessment that China's ECONOMY is overheating. It's inflation is still insanely low, with a CPI of around 2%. Productivity is booming, which means that the economy has the capacity to expand at a rapid clip. Fundementally, I like the Chinese economy for years to come. That said, there's way too much liquidity - don't touch Chinese equities. The best way to invest in China's growth is to invest in companies that supply China; the current lull in commodities is a great buying opportunity.

2007 Jan 23 11:14 AM

[QVM Group]

I agree with all of your comments, but am not able to debate the matter of the Chinese economy overheating. My references to that are basically a summation of the statements and actions of Chinese authorities. Perhaps "overheating" is not the best choice, but clearly the Chinese authorities are concerned about imbalances in export versus domestic consumption, misallocation of resources, runnaway pollution, inadequate lendig standards, and so on --- all of which fall into the general basic I called overheating. Maybe something like approaching limits to growth is more appropriate. The growth rate has caused many dislocations and the rate probably cannot be sustained without unacceptable consequences in the view of the Chinese government. It is the sustainability of the economic growth rate in China that should be of great concern to investors. If current growth rates are "baked in" the valuations are too high.

2007 Jan 23 12:45 PM

[Dave Malhotra]

I've been shorting FXI and lately have been getting my head handed to me. I agree the market is overheated but its irrationality might outlast my solvency. Stories like these make me extermely nervous:

www.chinadaily.com.cn/...
www.chinadaily.com.cn/...

What is it gonna take to pop this thing?

2007 Jan 24 02:41 PM

[Chris Thomas]

Dave, it might be safer to wait until the bubble bursts and then go bottom fishing. People lost fortunes trying to short the tech bubble - right call, wrong time. It could pop tomorrow, but I could equally imagine that this bubble could last until after the Olympics. I wouldn't have too large of a short position, else you could get burned pretty easily.

2007 Jan 24 03:01 PM

[Dave Malhotra]

Is it really a bubble? I am starting to have my doubts. FXI has a P/E of 17.86. The Dow Jones Industrials P/E is 17.7. The stocks that comprise FXI are probably growing faster than the ones in the DJI so FXI probably deserves a higher P/E. I think I may have made a huge mistake buying into the bubble thesis.

2007 Jan 24 08:11 PM

[QVM Group]

It would be inappropriate for me as a Registered Investment Advisor to offer you "personal" investment advice, through a chat tool like this. Anything I say here is general "impersonal" advice that may not be appropriate or suitable for you.

My own opinion for myself is as follows:

If any investment worries me and I am no longer confident in my original reasons for establishing the position (whether long or short), I exit the position. The world changes and we must change with it.

My article was not a call of a popped bubble, but rather an opinion that FXI is bubbly and got ahead of itself because its rate of change (ROC) was above its recent range and above the range of the emerging markets generally. It has since flattened out a bit, but is still above its normal range.

Whether China is in a bubble or not, it is a momentum market. Shorting momentum is exceptionally risky and is not something I would recommend. Momentum can be powerful and extended. We don't know the depth of the Dollars, Yen and Euro that may be willing to continue inflating the China markets.

Whether the FXI portfolio has a particular P/E is open to debate. After reading your posting, I checked with iShares.com to see what they had to say. The "fund fact sheet" on the official site for FXI said that the P/E and P/B are not available. Morningstar reports FXI P/B as 3.5 and P/CF as 8.3. Not sure how Morningstar knows a fact that Barclays does not.

If Morningstar is correct, those are not bubbly ratios. I recall (may bewrongly) that Geoff Considine published an article stating that iShares calculates P/E ratios by excluding loss making companies from the calculation. That approach may not be the same calculation as was performed for the Dow P/E you cite.

P/E always requires stipulation as to which P/E is used: (1) based on trailing earnings, (2) based on current earnings, (3) based on next year's earnings, (4) based on reported earnings, (5) based on reported earnings less "non-recurring" expenses, (6) based on GAAP or another set of accounting rules, and there are probably more possibilities. For a portfolio, do they average the P/E of the holdings or do they market weight the P/Es of the holdings. Do they include all or only some of the holdings. Who knows which one you are citing for FXI and for DOW.

Your point about PEG (price earnings to growth ratio) is a good one, but I don't know how to find out the earnings growth of the 25 stocks in the Xinhua index. Those companies may be growing earnings more rapidly or more slowly that the overall China economy. If iShares does not know P/E, they don't know earnings or earnings growth either.

The index creator and maintainer is FTSE/Xinhua at www.ftse.com/xinhua/en...

Their index fact sheet reports the Dec 29, 2006 "aggregate P/E" as 18.56. They got that from Nomura International. The Nomura site doesn't provide public information on Xinhua 25.

The point is that transparency is low, so all we have that is certain is price action. Price action has been exceptional and bubbly in the last several months. It may continue, go flat, decline in an orderly fashion or crash. It may do so now or it may do so later.

We can play or stay away and play a different game. If we chose to play, and we have a low tolerance for pain, we should probably go with the momentum and watch very closely with daily attention and a finger of the trigger to exit. If we have good reasons to believe strongly that we know something the market does not and have the ability to take a lot of pain ( and few do), we can bet against the trend, but we need to know why the market is wrong and when the market will figure that out. Money flows and othr technicals are probably best suited for that kind of determination.

Market Edge Second Opinion says about FXI; stay long, do not open new positions and that FXI is not a short candidate.

I believe in the adage, "Sell until you can sleep."

2007 Jan 24 10:31 PM

[QVM Group]

knowledge.wharton.upen...

Jeremy Siegel Interview on Knowlege @ Wharton

We have China, which looks like a bubble; even the Chinese officials said that it might be a bubble. They might be coming in to try to regulate that market in Shanghai, which has doubled just in the period of a couple of months. So you have to be very careful. Don't run after these, but if you set reasonable long-term allocations, I think you will be rewarded in your investments.

www.bloomberg.com/apps...;sid=awkRGTfDCpMM&...

China's `Blind Optimism' Spurs Stock Bubble Concern (Update4)
By Chen Shiyin and Zhang Shidong

Jan. 22 (Bloomberg) -- China's stock market has become the most expensive in Asia, leading strategists at Citigroup Inc., HSBC Holdings Plc and UBS AG to warn investors to stay away.

Shares traded on mainland Chinese exchanges cost twice as much relative to earnings as they did 18 months ago, and double the average for emerging markets, after extending last year's 121 percent rally in the Shanghai and Shenzhen 300 Index. The surge sent their value above $1 trillion for the first time and prompted the government to caution shareholders that ``blind optimism'' is driving gains.

2007 Jan 24 11:01 PM

[QVM Group]

Article Describing Chinese Market in a Way that Sounds Like USA 1929
(News from the Middle-East --- a non-US perspective)

The whole article is worth a read. Here are small extracts

Shanghai: Chinese taxi drivers trade stocks from their cars via mobile phones, and housewives queue at brokerages with bags of cash.

But investors have coined a phrase to describe China stock market's record-breaking bull run: a "rational bubble".

... Classic signs of a bubble are abound in China.



GulfNews

China stock rally still not a bubble
archive.gulfnews.com/a...
01/20/2007 07:48 PM | Reuters

2007 Jan 25 12:13 AM

[John Gaats]

I have a contrain view: China, too little, too slow. And I am talking about ways we can invest in China. They are about 56 Chinese ADRs here in New York. And we can invest in HongKong through FXI. Given the trend that Chinais growing at double digits and YUAN is appreciating against the $. We know we need them. Both NYSE and NASDAQ have set office too attract more Chinese firms to the Big Apple.

I also don't believe your metrics is right. Comparing PE, PB, PEG is not a standard approach here in the U.S.. You cannot use P.E. to justify why this sector is better than others. You cannot even use PE, PB, PEG to justify market valuation for individual stocks. I have no problem when you use these numbers to say that you are uncomfortable with FXI. The question is why don't you also use the same metrics on other 1000 U.S. stocks? For example, MA.

My expectation is that FXI and PGJ will be winners again this year.

2007 Jan 25 01:13 PM

[QVM Group]

Actually you have a crowd view of China and a view contrary to mine.

I believe that I said what you are saying -- that P/E is an elusive metric that is used as if it were a standard, but in fact can be and is regularly based on widely varied formulas.

Better than Chinese ADRs for those who wish to be more conservative might be to invest in companies from developed countries but which have major growth engines established in China in fast growing sectors there. That idea requires evaluating the percentage effect of their China business on their total business, but the exercise could prove fruitful.

You may well be right that Chinese investments will continue to rise in 2007. I have not made a timing call, only an observation that the pace of price change is ahead of itself and that the pace cannot continue -- and that overheated price change typically is followed by declines.

2007 Jan 25 01:58 PM

[John Gaats]

I respect your opionion as I respect mine.

For my own investment, I disagree with you on developed country approach. The big picture is that developed world will have 2-3% growth this year. In a funnyway, their stocks reflect that. AZ is a good example. Invest everywhere (including China). Grow very slowly. The problem is, it also falls big if the dow falls big time.

My hope is that we can identify some alphas so that we can make a profit even though the Dow is going to be tough this year. Theoretically, FXI should have very low correlation with DOW. However, I feel FXI is very depressed. Probally artificially. I don't mind peopel's free opinion. I just hope we don't penalize our investment because of wrong labeling.

Again, I respect your opinion. Happy investing!

2007 Jan 25 02:39 PM

[QVM Group]

CORRELATION of FTSE/XINHUA 25 to RUSSELL 3000

Using IWV (the tracking ETF) for the Russell 3000 (a broad US stock market index), the correlation to the FSTE/XINHUA 25 (the index which FXI tracks -- FXI to new to be used itself for all the data here) is +0.14 for 1 year daily, +0.37 for 3 years weekly, and +0.29 for 5 years weekly.

Source: Correlation Tool (stated uses returns) in Financial Advisor section of the iShares website.

2007 Jan 25 03:00 PM