Hold China Without Getting Burned

Includes: AXJL, FXI, PGJ
by: Kenny Landgraf

Thursday we learned that Merrill Lynch (MER) was writing down $8.4 billion in mortgage-related securities (WSJ 10/25/2007). I find myself asking how we got to this point? Didn’t anyone see the housing bubble coming? Haven’t we learned from history? And, the biggest question: what will be (or currently is) the next bubble?

Market sages are warning that China will be the next bubble to pop. One can only look at a chart of the ascent of the Chinese market and find similarities when comparing it to the NASDAQ market in 1999 & 2000. We all know how the NASDAQ bubble ended. Along with the fundamental truths of the NASDAQ stocks in 1999 – 2000 how technology was going to change the world (which it has), we hear the same “potential” stories about Chinese stocks and the emerging dragon economy of China and east Asia. However, mixed in this “dragon cocktail” of fundamental positives (emerging economy, companies going public) are two negative factors. The first factor is the momentum players who jump on the “mo” train and are happy to ride until the wind gives out. The second negative factor is investors’ use of margin when investing in this sector.

Margin is the smoking weapon lying next to all the bodies. Excess margin brought down the market in 1929. Margin and extreme valuations brought down the NASDAQ starting in spring of 2000. Margin and off balance sheet borrowing brought Enron to its knees and eventually bankruptcy. Our sense is that margin is one of the fuels being thrown into the fire of this smoking market.

Our advice to investors is as follows: If you have exposure to China and the remaining emerging markets, maintain and cut back your allocations as they grow. If you have a 5% allocation to China and it grows to 10%, take some of your winnings and rebalance your position back down to 5% at some point. If you are using margin to leverage your exposure, ask yourself how much of a loss you can tolerate. If you do not have an allocation to China and would like one, it is not too late. We would recommend a 5% maximum allocation using either mutual funds or ETFs. Our recommended funds include: U.S. Global Investors China Reg Opp [USCOX], Eaton Vance Greater China Growth [EVCGX], and Fidelity China Region [FHKCX]. The ETFs we would consider are: iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI), PowerShares Gldn Dragon Halter USX China (NASDAQ:PGJ), and WisdomTree Pacific ex-Japan Total Dividend Index (DND).

You should expect there to be those “Kool-Aid drinking” investors who will be mad at the naysayers and at the same time, there will be those giving cautious comments just like they were about Greenspan and his irrational exuberance speech in the late 1990s. The fact remains there is nothing wrong with having an allocation to China and emerging markets just like there was no problem with having a similar allocation to the NASDAQ in the late 1990’s. The question in every investor’s mind should be: 1) how much am I willing to lose; and, 2) at what point or circumstance would I sell this position? If this determination is made up front, an investor will be successful in his investing and traverse the crash when it happens. In the rodeo world, everyone enjoys watching the bull buck. But few will be able to hold on to on this bull when the downside crash begins.