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|Includes: iShares China Large-Cap ETF (FXI)

June 25, 2013

S&P 500 1573.09

FXI 31.70

The Shanghai Composite closed last night at 1959.51. That is down 14.8% for the month of June, 2013. That is a large drop. Since 1991 there have been only three times in a 12 month period where you have had a drop of that magnitude in a single month.

The Bank of China fully understands that large stock market movements are the transmission mechanism of financial liquidity and monetary policy to the real economy. They will do whatever needs to be done to move this market higher.

Chart forSSE Composite Index (000001.SS)These are the previous three periods of large one month drops:

1993.05 -31.2 935.48

1994.07 -28.8 333.92

2008.10 -24.6 1728.79

2013.06 -14.8 1959.51

To outperform the market indexes it is necessary to anticipate the future moves of the global asset allocators. What are these institutions using as a basis for making radical changes in sector and country allocations?

Let me suggest that they are using factors that fall into two categories consisting of valuation factors and monetary factors. The main etf for the Chinese market, the "ishares FTSE China 25 Index Fund" is trading at 9x trailing earnings and 2.2x cash flow. This is in an economy with a 7% long term growth forecast.

Chart foriShares FTSE China 25 Index Fund (NYSEARCA:<a href='' title='iShares China Large-Cap ETF'>FXI</a>)

On the second front, monetary factors, the Bank of China is going to respond to the market panic with exactly the same massive liquidity expansion as they used in 2008.

2008 September 2293.78

2008 October 1738.79 Panic

2008 November 1871.16

2008 December 1820.81

2009 January 1990.66

2009 February 2082.85

2009 March 2373.21

2009 April 2477.57

2009 May 2632.93

2009 June 2959.36

2009 July 3412.06

On the first page of the Wall Street Journal is the headline "China's "Shadow Banks" Fan Debt-Bubble Fears ." The Wall Street Journal hates China. How do you explain to your followers of the "small business man made America great with free markets" to the reality of 2.5% long term economic growth when a communist oligarchy is able to churn out 7%.

The important thing to remember when you are talking about China you are talking about a country with a household savings rate which was 16% in 1990 and was 30% in 2010. You have massive amounts of new domestic capital flooding the investment system every year. A country expanding at 7% needs massive amounts of capital to maintain the investment rate to support that growth rate.

I highly recommend a 2008 book by the Korean economist Ha-Joon Chang, "Bad Samaritans, The Myth of Free Trade and the Secret History of Capitalism." This is a solid, well documented, easy to read, presentation of the case for state managed capitalism and explains clearly the Asian economic model. The book sells for $10 in paperback or on kindle.

The Bank of China is going to be under enormous pressure from their political bosses to do something. They will err on the side of making sure they are not sent for reeducation. To the Chinese Central Committee capitalism is a tool to provide resources for the party. Those resources create social stability and an expansion of military power.

FXI (China ishares ETF) is the investment idea for the next six months.

Disclosure: I am long FXI.