The Tycoon Report

Is the China Dream Finally Ending?

Monday, December 3, 2007 | Wayne Mulligan

I’ve had a number of Tycoon members write in recently asking about the current downturn we’ve been seeing in the Chinese equity markets.

I mean, we keep hearing about all the great things happening in East Asia, right?  I even have personal friends who are currently working and living there ... and they don’t see any visible signs of a slowdown occurring.

So then, why has the Shanghai Index dropped almost 1,200 points in two months? 

Well, we’ve seen a number of unfortunate market events come out of China recently:

For a brief moment, the country boasted the largest company in the world, PetroChina – the company had a market cap of approximately $1 trillion, but has since seen its valuation drop by almost one third in under a month.

Even the legendary investor Warren Buffett has already cashed out of his PetroChina holdings (for a profit, of course), citing the Shanghai market as unsustainable.

This comes on the heels of the news that the Chinese government instructed banks to freeze lending until 2008 – that means businesses, homeowners and even stock market investors who relied on credit now have NO access to new capital for another month.

If all this weren’t enough to make investors run for the hills, let’s not forget that China is facing mounting international pressure to let its currency appreciate further and faster – the latest requests are coming out of Japan, a country whose economy greatly depends on China and Hong Kong.

The country is plagued by inflation, international pressures to open its currency up which would only hurt its precious export-driven economy, and a stock market that’s dropping by the minute – so why, oh why should a US investor want to buy into such a mess abroad when we’re in a fine pickle right here at home?

Well, I’ll tell you…

As investors, we have to think like Bernard Baruch – the man who only “bought his straw hats in the winter.”  That quote is from his famous analogy of buying straw hats in the winter when nobody needed one, and then selling them in the summer when the cool, comfortable headgear was in high demand.  The same applies in any market ... especially the stock market.

So let’s approach this situation by assuming that China’s stock market is going “south for the winter.”  Then the question becomes, will its prospects brighten for the summer?

Now, I can write all about the fantastic elements of China’s economy.

I can talk about how quickly the country is growing, or how much the Olympics will affect the business climate in 2008, or how many US companies (including the NADSAQ) are pouring millions and even billions of dollars into China’s economy.  Sure, I could do that.  But then somebody else could come along and completely disagree with everything I said.
   
So I’m not going to even discuss those things here.  Because there’s one thing about China’s economy that nobody can argue or disagree with: China’s demographics!

This is a country with 1.4 billion people – the U.S. only has roughly 280 million people, so that’s about 5 times the size of our country!

Back in 1981, almost 53% of China’s population lived below the poverty line.  Today, that number is under 8% - that means China has almost 500 million people who were once poor and no longer are!

That’s half of a billion people who are now part of the middle class and want to buy goods, services and products commensurate with that newly found social status.  Goods like cars, homes, technology products, etc.

The aggregate demand that has been built up in this country is only just beginning to be unleashed – China is far and away the greatest wealth generating opportunity for the next 20 – 30 years!

Long-Term Opportunities

Now, is this to say that China’s market couldn’t go down further?  Of course not – in fact, there’s a good chance the market will continue to correct throughout the remainder of the year.

But I’m not talking about investing in China for the short term – these are long-term factors we’re talking about here (demographic shifts, aggregate demand, etc.), and therefore, we need to take a long-term perspective when looking at this country as an investment opportunity.

So, if you have a belief in this sector as I do, then the question shouldn’t be, “Should I invest in China?”  The only question in your mind should be, “When should I invest in China?”

Once the correction is finished, and the market bottoms out and begins to turn, you should definitely be looking for opportunities there.  Now, I know how difficult this might sound for a U.S. investor, so I’m going to give you a bit of advice:

Buy the sector, not the stocks!

Meaning, if your time and knowledge of the market are limited, then you should avoid trying to pick individual stocks – instead invest in the ENTIRE sector.  One of the best ways to do that is by looking for great ETFs.  Here are two that will give you some exposure to the Chinese equity markets without forcing you to rack your brain too much looking for opportunities in company names you can’t pronounce or understand (e.g. Kong Zhong Corp.):

1. The FTSE/Xinhua 25 Index – The symbol is FXI, and it contains China’s 25 largest H-Share and Red Chip stocks.  So think of it as an index of Chinese blue chips.
2. If you’re looking to spread your bets around even further, then you could take a look at the SPDR S&P China ETF (Symbol: GXC) which pretty much tracks the entire Chinese equity market.

Like I said before, think of this as “winter time” for China’s stock market.  Smart investors will be loading up on cheap stocks now so they can sell them for a handsome profit when the summer comes around.

If you’d like some help in identifying market trends overall, I highly recommend taking a look at the CRISS system my colleague, Christopher Rowe, just launched.  Unfortunately, the VIP pricing period has ended, but it’s still a steal when you compare it to the potential profits you could make by learning to invest like Chris.

Have a great week!




Wayne Mulligan
Contributing Editor
The Tycoon Report



Monday, December 3

10:00 - ISM Index (for November): Consensus 50.5

Big Picture: A modest gain follows four consecutive declines, as production will provide the fuel for a return above 50 after the October contractionary reading.  New orders and employment are expected to hold near October levels.  Watch imports after the sub-50 October reading, but export orders are running strong.  Prices paid (input costs) are expected to rise with energy costs, but the lack of manufacturing pricing power leaves very little effect on inflation.

Implications: The ISM report is a national survey of purchasing managers which covers such indicators as new orders, production, employment, inventories, delivery times, prices, export orders, and import orders.  Diffusion indexes are produced for each of these categories, with a reading over 50% indicating expansion relative to the prior month, and a sub-50% reading indicating contraction.  The total index is calculated based on a weighted average of the following five sub-indexes, with weights in parentheses: new orders (30%), production (25%), employment (20%), deliveries (15%), and inventories (10%).  The ISM is one of the first comprehensive economic releases of the month, typically preceding the employment report.  Though it covers only the manufacturing sector, it can often provide accurate hints regarding the tone of subsequent releases.  During periods of inflation concerns, the prices paid and vendor deliveries indexes often determine the bond market's reaction to the report.

17:00 - Auto Sales (for November): Consensus 5.2M, Truck Sales (for November): Consensus 7.1M

Big Picture: A small decline should lead to massive year-end discounts and increased sales in December, and November's estimate is the slowest since July.  Higher gasoline prices may be having a larger effect on light truck sales.  Domestic sales are running at a 12.3 mln average pace year-to-date, from 12.8 mln in 2006.  Imports are gaining market share, reaching 24% in October from a 22% average in '06 and 20% in '05.  With just 20% of the weight in retail sales, the decline will only have a modest effect on sales.

Implications: Auto and Truck Sales measure the monthly sales of all domestically produced vehicles.  They are considered an important indicator of consumer demand, accounting for roughly 25% of total retail sales.  Demand for big ticket items such as autos and trucks tends to be interest rate sensitive, making the motor vehicle sector a leading indicator of business cycles.


Wednesday, December 5

8:30 - Productivity-Revision (for Q3): Consensus 5.5%

Big Picture: Cyclical and structural productivity growth has softened, leaving a slower growth trend for the economy.  Meanwhile volatile compensation costs and slower productivity gains leave stronger unit labor costs -- the Fed's key read on labor-based inflation pressures.  The big picture is that trend productivity growth plus trend labor force growth equals potential GDP growth -- what some call the economy's longer term speed limit.  Labor force growth runs near 1% annually.  If structural productivity growth is 2%, potential GDP growth is near 3%.  Over the long term, strong productivity growth is a win/win situation, resulting in weak unit labor costs and the stronger wage growth allowed through the increased output produced.  Strong productivity comes with a cost to near term employment (labor) demand and benefits in lower inflationary pressures and a higher standard of living.  Current trends reflect a weakening in trend productivity and a resulting lift in inflation pressures.

Implications: Nonfarm productivity and costs provide measures of the productivity of workers and the costs associated with producing a unit of output.  During times of inflationary concern, the unit labor cost index in this report can move the market.  If productivity is falling, unit labor costs may be rising faster than hourly earnings and other labor cost measures.  Because productivity can be quite volatile from one quarter to the next and because the previously released GDP report will give a good indication of productivity growth, this report seldom has a significant impact on the market.

10:00 - Factory Orders (for 0.4%): Consensus 0.4%

Big Picture: Non-durables are again expected to provide the gain, as durable goods orders reportedly fell -0.4%.  Ex- transportation orders are also expected to edge higher -- marking the 3rd rise in four months.  Core capital goods (proxy for business investment) aren't showing much strength, down over the last 6 and 12 months.  The Spring/Summer lift is fading, but factory orders show stronger annual growth (4.6%) tied to weak growth a year ago.

Implications: Factory orders consist of the earlier announced durable goods report plus non-durable goods orders.  The report is very predictable with nondurables the only new component.  Nondurables consist of such items as food and tobacco products, which grow at a fairly consistent monthly rate, so that market forecasts for this report are far more accurate than for the durable orders report.  In addition to seeing nondurables for the first time, the market also watches for revisions to the durable orders data, which can be significant.  At present, durable goods orders sum to about 54% of total orders.

10:00 - ISM Services (for November): Consensus 55.0

Big Picture: The services sector continues to expand at a respectable clip after dipping from a 14-month high of 60.7 in June.  Household spending is finding its way to the largest economic sector despite higher gas prices, low consumer confidence and market volatility.  New orders are expected to hold in the mid-50s.  Inventories have bounced around pretty hard, but the story is better told by 12-month growth of around 53.0.  Prices paid are holding just above the 3-month average, at around 62.7.  Employment (seasonally adjusted) is a bit of a sore spot, as it teeters just on the growth/contraction 50 level.

Implications: The non-manufacturing ISM report is a national survey of purchasing managers which covers new orders, employment, inventories, supplier delivery times, prices, backlog orders, export orders, and import orders.  Diffusion indexes are produced for each of these categories, with a reading over 50% indicating expansion relative to the prior month, and a sub-50% reading indicating contraction.  The index should be far more indicative of the broader economy given its inclusion of service- producing as well as good-producing sectors outside of manufacturing.  However, the short history of the index dates to only July 1997 and doesn't provide the insight of a longer period inclusive of varied economic climates.


Thursday, December 6

8:30 - Initial Claims (for 12/1): Consensus NA

Big Picture: Weekly initial claims can be volatile, as recent movement suggests increased damage to the labor market.  Layoffs (seen in initial claims) have been rising, and reached above 350K in late November while hiring (seen in continued claims) showed a sharp rise to leave the largest levels in two years.  Claims provide a nearly real time read on layoffs and the labor market, as the unemployment rate reflects the broader combined read of layoffs and hiring.  The 350K for claims is worrisome, as a 375K level may be the final blow to the economy on its way to recession.

Implications: Initial jobless claims measure the number of filings for state jobless benefits.  This report provides a timely, but often misleading, indicator of the direction of the economy, with increases (decreases) in claims potential signaling slowing (accelerating) job growth.  On a week-to-week basis, claims are quite volatile, and many analysts therefore track a four-week moving average to get a better sense of the underlying trend.  It typically takes a sustained move of at least 30K in claims to signal a meaningful change in job growth.


Friday, December 7

8:30 - Nonfarm Payrolls: Consensus 75K, Unemployment Rate: Consensus 4.8%, Hourly Earnings: Consensus 0.3%, Average Workweek: Consensus 33.8 (all for November)

Big Picture: Nonfarm Payrolls -- A small 65K gain is shown, after the outsized 166K October jump.  116K average is just below 3 and 6-month averages.  Another set of declines in construction and manufacturing leave an eighth consecutive decline in good producing payrolls.  Private service providing payrolls are expected to rise 90K.  A fourth consecutive decline in retail is expected.  Government payrolls are expected to add just 15K.  Unemployment Rate -- Expected to rise to 4.8%, the highest since July 2006.  March marked the 4.4% cyclical low.  The 5% rate is generally considered to be inflation neutral full employment (i.e. NAIRU).  Hourly Earnings -- An 0.4% rise in earnings is expected to follow the 0.2% October gain.  Leaves a slight lift in annual growth to 3.9%, and reached a six-year high of 4.3% yoy in December.  Average Workweek -- Expected to hold at 33.8 hours.  Showed a small variation over 2007 from 33.7 to 33.9 hours.

Implications: The employment report is actually two separate reports which are the results of two separate surveys.  The household survey is a survey of roughly 60,000 households.  This survey produces the unemployment rate. The establishment survey is a survey of 375,000 businesses.  This survey produces the nonfarm payrolls, average workweek, and average hourly earnings figures, to name a few.  Both surveys cover the payroll period which includes the 12th of each month.

10:00 - Michigan Sentiment-Prel. (for December): Consensus 75.5

Big Picture: Expecting nearly flat growth after the -16% four month plunge.  High energy prices, falling home prices and credit concerns continue to worsen the economic outlook.  Already below the 81.8 low during the 2001 recession, and is the lowest since the 13-year low during the Oct 2005 Gulf Coast hurricanes.  1-year inflation expectations running in the 3% to 3.5% range.

Implications: The Michigan index is almost identical to the Conference Board Consumer Confidence index, though there are two monthly releases, a preliminary and final reading.  Like the Conference Board index, it has two subindexes -- expectations and current conditions.  The expectations index is a component of the Conference Board's Leading Indicators index.

15:00 - Consumer Credit (for October): Consensus $5.0B

Big Picture: A return to near average annual growth is expected, after the weak September and strong August.  12-month average growth comes in at $9 bln, $10.3 bln year to date.  Revolving credit (6.9% yoy) is expected to top the gain in nonrevolving (3.2% yoy).  Annual growth is expected at a moderate 5.3% yoy.  Compares to a decade low 3.4% in April 2006 and a 13% yoy pace in mid 2001.

Implications: This monthly measure of consumer debt is volatile and subject to massive revisions.  It is also released well after every other consumer spending indicator, including weekly chain store sales, auto sales, consumer confidence, retail sales, and personal consumption.  For these reasons, the market almost never reacts to the consumer credit report.  Consumer credit is broken down into three categories: auto, revolving (i.e. credit card), and other.  Since we already have indications on total consumer spending well before this release, there is little to be gained from learning what portion of spending was financed through acquisition of debt.  Periods of strong spending can be accompanied by relatively weak credit growth and vice versa, so this measure fails even as a coincident or lagging indicator.


Source: www.Briefing.com