Emerging Markets Bubble Is Tested as Chinese Stocks Crack

Includes: EEM, EFA, FXI, PGJ
by: The Sovereign Society

At least from my home here in Montreal, the emerging markets “bubble” appears to be pricked.

Though it’s still too early to tell if this big rally off the October lows is finally over for emerging markets, investors are glued to the price action in Shanghai this summer for clues if this is a correction or the “beginning of the end” for the asset class.

Leader of the Pack or the Biggest Bubble?

Over the last ten years no other global sector has outpaced the MSCI Emerging Markets Index (NYSEARCA:EEM). In fact, major market stocks have been a losing bet since 1996.

Indeed, advanced economy markets as defined by the MSCI World Index and the MSCI EAFE Index (NYSEARCA:EFA) (excluding USA) have declined an average annualized 1.67% and 0.43%, respectively, since 1999.

The MSCI Emerging Markets Index, however, is up 7.66% per annum over the last ten years. The BRICs of Brazil, Russia, India and China have rallied 12.82% per year since 1999.

Emerging Market Bulls Hold their Breath as Xinhua dips into Bear Mode

Stocks in Shanghai have now declined 20% from their highs this summer – defined as a bear market.

I don’t read too much into the “20% bear market or bull market rule,” but it’s symbolic of the long awaited decline since Chinese stocks hit a low last October. Shanghai equities are up 52% in 2009 and have surged a cumulative 128% since last fall.

Is Chinese Growth Solid?

The Chinese economy continues to grow this year mainly because of massive government spending and reckless bank credit growth.

The “easy money” has been flooding into domestic stocks and real estate. Meanwhile, the Chinese central bank recently warned about excessive credit.

I seriously doubt the Chinese growth miracle this year because I can’t imagine where exports are going when more than 50% of their sales head to the U.S. and Europe – both in savings mode.

Also, contrary to all the hoopla about renewed Chinese commodities consumption, oil imports fell 2.9% the first six months of 2009. This contradicts the recovery story already incorrectly baked into stock prices everywhere since March.

China Leading the World’s Stock Markets (Or Not?)

Over the last three years we’ve seen a gradual shift in market sentiment… investors are now riding the stock market cycle based on the primary trends in Chinese equities at the expense of New York. That kind of thing was unheard of five or ten years ago.

There’s no arguing that China is a major force in global trade and her voracious appetite for raw materials primes her massive manufacturing engine.

Yet I find it pretty scary that we’ve grown increasingly reliant on trends in China, which is still a Communist country masked by distorted economic data. After all, the Chinese fudge their books just like everyone else.

I can’t say with any certainty if this is the big correction we’ve all been expecting. Major averages have not violated support levels yet. Stocks worldwide also declined about 9% off their highs from mid-June until mid-July before violently reversing. The same might happen now. Watch China for clues for market direction.