Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

October Monthly Edition: Part 2 Funds Fleeing All China Stocks

Funds Fleeing All China Stocks

For those of you who are following this wasteland of a sector, you might have noticed a big, giant whoosh down in all the China small cap stocks from their already absurdly oversold levels, coupled with a 40% hammering of many of the China large caps that had previously been immune to the fraud issues.

In case you were wondering, this was another news driven sell-off, where many of the funds who are more "fundamental" in their strategy said just "Get Me Out" of this thing with no regard for price.

The catalyst for the sell off was what I'll call "non news news".

This past Friday, Reuters interviewed SEC Enforcement Director Robert Khuzami who commented specifically about the investigators inability to obtain the audit work of Deloitte Touche's China subsidiary on Longtop Financial (NYSE: LTP). This was one of the most very high profile fraud cases as it was a Goldman Sachs IPO.

Delloite's China division refused to produce its records stating it would be a violation of Chinese law to do so. Chinese law forbids the production of these documents under the guise of a National Security issue.

Then, on this past Monday, James Doty, the chair of the US Public Accounting Oversight Board, stated as it relates to a proposal to do joint inspections with Chinese regulators:

"we will have to consider using the tools we have at our disposal, and which the Congress gave us for this purpose, to protect investors,"

Chinese Regulators and US Regulators sat down in July to discuss moving this forward, and they agreed to meet again this month. According the Bloomberg, the date has not been set yet.

Lynn Turner, former chief accountant for the SEC, was interviewed by Bloomberg on this matter. She stated the PCAOB has the authority to impose a variety of sanctions on auditors that won't cooperate with inspections including revoking their registrations.

The net possible result of all this if the Chinese won't cooperate and allow the inspections? The PCAOB could revoke the registrations of all the audit firms who do business in China. This would result in all China based companies failing to comply with SEC reporting standards. They would all be relegated to the Pink Sheets as non reporting companies, or possibly completely de listed as US public companies if the SEC chose to go there.

The reason I say this was "non news news" is that it has been widely known investigators have not been able to obtain these records on Longtop under the guise of national security issues for some time. I had read about it months ago.

The only thing that has changed is there's a couple of regulators answering some questions to the news media about the issue.

However, it does appear the US is beefing up the public rhetoric on this issue, and looking for some sort of resolution to the problem.

The market is interpreting this to mean there's now a whole new level of risk which could effect all the companies with China businesses who trade with US listings. The honest companies could now get the axe as well, and the market is pricing in that risk.

Congress Gets in the Act

News out of the US Senate is not too China friendly either. Our legislators voted 79-19 to pursue a bill which would allow the US government to impose duties on imports from countries who were not allowing their currencies to float in the open market, thereby creating an unfair advantage to the offending country.

This bill is targeted directly at China on the premise their exports to the US remain unfairly competitive as their currency is artificially weak. A stronger Chinese Yuan would make their exports more expensive in the US, and possibly bring jobs back stateside according to the Senate Logic.

Guys- if you want to bring back jobs, just drop the corporate tax rate to 15%, and figure out an amnesty program to allow companies to repatriate capital. Nothing to it.

The Net Result

The net result of all this negative China sentiment sent stocks reeling to all time lows. All the small caps with any institutional sponsorship dropped 20% to 40% on high volume.

The Chinese markets, where fraud is not issue, are now trading at 2 year lows. The global environment has investors believing China is going straight from an overheated inflationary economy to a deep recession. The markets are not pricing in a "Soft Landing" scenario for China.

There's an Op Ed piece in the Wall Street Journal today suggesting this is not the time to publicly pressure China on the appreciation of the Yuan. It has been appreciating slowly over the last couple of years as the Chinese promised, and to the rest of the World the bill before Congress appears to be a desperate recognition we're trying to legislate our way out of this recession.

It seems unlikely this inspection issue will end up in a worst case scenario. Overtly challenging the Chinese with public threats is not the way to achieve the inspections.

The Chinese are extremely sensitive to public challenges, and won't care if all their companies lose their US listings if publicly chastised.

The resolution must happen behind closed doors, and the Chinese will want something in return for allowing the inspections.

All we need is a resolution to the following issues to see strength come back into the sector:

  • Economic indicators suggesting China's economy will have a soft landing- with lower inflation and slower growth, as opposed to crashing into a recession.
  • A perceived resolution to the banking and Sovereign debt issues in Europe.
  • The market's belief all Chinese stocks won't be de listed which requires help from the Chinese regulators.
  • Signs the US is not falling into a major recession.
  • The Fraud issue quieting in people's minds.

My thoughts on the macro picture? Glad you asked. Getting all the aforementioned issues resolved is no small feat, but it's worth hanging around for.

These stocks are getting so cheap there's going to be a massive rebound when all this smoke clears and the ship rights itself.

I don't know when all this will happen, but when it gets started there will be a 2 year bull market with some of the stocks appreciating 4 and 5 fold from current levels.

At present I still own all of the stocks in the portfolio. However, I'm now 90% in cash, and for the most part on the sidelines waiting for this irrational flight from risk to pass.

I believe all these issues will get cleared up eventually, and when they do there will be a massive run in some of these stocks as many of them power past valuations below the cash they have in the bank, straight to 10 times their next 52 weeks of earnings power.

When we get there, many stocks traded at $1 to $5 will be in the teens. The stocks in the China sector are now much like the Dot-Coms in 2001- fortunes were made investing in the right companies when the market thought all technology companies were closing their doors. If you were around then, watch this sector. Eventually, it will be Deja Vu all over again.

Warmest Regards,

Larry Isen



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.