The Magic 444 number is very close now in the Dow Jones China index . It could be too esoteric for financial analyses, but to put it simply 444 has the same meaning for the Chinese as 666 for Christians. This bubble in Chinese market is unsustainable and has been created by the problem of trying to keep the Jinn in the box. Capped by an artificially low rate of exchange of YUAN, the local currency is still chasing a relatively small stock market. Suppressed low wages and uneconomic (when all real expenses accounted including environmental and health) production costs fueled by "bad" loans from the State sector cannot be sustained for a needed healthy rate of growth. The Chinese Dragon has grown up and needs to be on a healthy diet of financially responsible consumption. The recipe for this diet consists of growing a middle class and increasing the amount of savings reinvested into economy.
What is necessary for this positive outcome? For starters, a transparent capital market and a recapitalized banking sector with recycled "bad loans" for state-owned enterprises. Currently, bubble mentality is taking over with mutual funds and black boxes chasing the last 20-30-40 % of the upside, afraid to miss the opportunity. Woos and Guys are taking their savings and putting "their riches to work" in the parabolic last leg of the bull market before correction. The whole world is getting crazy with intoxication of "free" money.
But trouble is already here. The US is facing stagflation – a stagnation of economic growth in real terms with increasing inflation in all basic goods (energy, food and commodities). For all those goods advertised on Google, you need the bricks, not the clicks, to produce them and now you have to compete for them with Woos and Guys. China is already preparing for a necessarily painful pullback to reality. The stock market bubble needs to be deflated, and the sooner the better. Once liquidity dries out the market will plunge 30-50% to its still solid bull uptrend line. A lot of reckless people will be hurt as usual. Shock waves will hit all asset classes. PPT will try to paint the picture and the USD will fly again as a "safe haven" when all emerging markets take a hit.
Such an outcome could be disastrous or very positive for China, emerging markets and the world in total. In my positive scenario, China needs to sterilize excess liquidity by increasing real rates and reserve requirements for banks. Currency control must be relaxed so that excess capital can go overseas and secure real assets for future growth. Part of China's currency reserves must be used for recapitalizing the banking sector. There must be a cleaning out of all nonperforming loans and also reserve diversification away from the "reserve currency of choice", the USD. This must be sped up by way of deployment of the investment agency and increasing the share of other currencies, gold and strategic reserves of oil and basic materials.
Am I dreaming or am I just reading to you out loud the recent headlines coming from China? I know my limits – it is the headlines. The bubble will be popped in the nearest future, a lot of "wealth" will evaporate, and those who survive will come back to the safety of bank deposits with a rising Yuan and higher deposit rate. The shock will keep people in China out of the market for a while like with Russia after 1998. After the panic, SAFE investment agency and Chinese banks will step into the market at around the 200 level and buy back what they have sold to "foreigners." Increasing the minimum wage will help to stimulate internal consumption growth which will become a solid base for healthy economic growth in the range of 5-7% per year for decades to come.
There's no magic here, but what is very disturbing for the US consumer is the fact that even if wages in China double, still nobody will be able to compete with China. The US economy will continue to effectively import inflation with rising prices on all basic goods produced in China. This is the phenomenon of imbalances in the world. If the Dow loses 50% within the next 5 months, a depression in the US will last for years, while the Chinese market would be back in 2008 after the same type of loss.
Can you imagine in the US a doubling of wages, energy consumption or copper consumption per capita? But this will be a reality in China within the next 3-5 years, which will lead to a disproportionate rise in consumption of basic goods and big ticket items a the biggest part of income now is spent on basic necessities like food and housing. And what is the limited part in my vivid imagination? Real assets, gold and silver as the ultimate store of value and hedge against a falling USD and political disturbances, commodities which are close to peak in production and still perceived as very risky class of assets. Turn on TV and you will hear about oil at 40 dollars. Talk to insiders and they are still calculating copper price at one dollar per pound. Nobody could believe that this commodity bull is for real and not for a couple of years.
I pray and hope that the shifting of power from the US in its late stage of empire from dominant force to multi-polar sustained political environment will not be disturbed by war and an effective reduction of demand from a growing population. In all other cases, careful investment in resources, particularly in junior companies, will pay out handsomely. Look for trustworthy management, stable political situation and economical resources in the ground. Even if all assets are initially hit by a sell off, you will be very lucky if you have an opportunity to add to your positions in gold at 50USD, silver at 1.0USD and copper at 8 cents in the ground.
Do not bet your house; use margin or time against yourself in option trades. But if you have capital, deploy it carefully and be ready to buy more on any pull backs. Be twice as careful in this market because small cap stocks are easily manipulated. But volatility will be your friend with proper risk assessment, homework and discipline. Common sense secrets of trade could help you on initial steps. Go for small companies which are close to production and in the process of economic assessment of already discovered reserves. You will have double leverage of rising prices and increasing asset base of the company.
I will mention few companies for your further study. Silver Wheaton (NYSE:SLW) has a very interesting model as they are effectively a silver bank with a high leverage to silver prices. Silver Wheaton is a big cap silver company and is well on the radar screen of the investment crowd. Such stocks will benefit on initial capital inflow. Tanzanian Gold Royalty Company (TRE) is highly leveraged to the price of gold and is managed by the legendary Jim Sinclair who is not reading the gold story, but writing it. Sterling Mining (SRLM.OB) will start production in December 2007.
Avino Silver and Gold Mines (ASGMF.OB) owns formerly producing mines and is close to production and has value of only production assets close to recent market cap. Mines Management (NYSEMKT:MGN) was able to buy out huge deposit in mining friendly Montana at a boot sale price tag and is now actively moving into production. And of course, my story will not be even close to give you the real feeling of the bull market for years to come without mentioning Lundin Mining (LMC) and the Lundin family itself which is behind many successful projects. The recent take over of Tenke Mining has created one of the most promising intermediate copper/zinc producers in the world. Be ready for M&A fever around such companies which will drive commodity markets to new highs after the consolidation phase is finished.