Friday, June 01, 2007

Off to the races?

Following last Thursday’s key reversal, I wrote a post about a possible near term top in the market. The Q’s were used as an example. Wednesday morning, with Shanghai down 6+% overnight, I thought a confirmatory down day was a lock. The market obviously had other plans! It shook off the initial jitter in about half an hour and never looked back! The S&P closed at an all-time high! While the Naz is still below this year’s high water mark, plenty of other markets have made new highs in the last two days. The list of international ETFs that did so included the usual suspects: Brazil (EWZ), Mexico (EWW), Canada (EWC), and Germany (EWG). South Korea (EWY) also joined foray as its market held up the best Tuesday night in Asia. These ETFs have seen early action in the past couple of days that may finally indicate that retail investors may finally be back.

I had thought that we would be seeing some down side before new highs. So much for that. For want of an explanation, we may look to the “sovereign funds” that has been a hot topic following Chinese investment in the Blackstone Group. But that is strictly looking for an excuse post hoc. Whether it’s due to the old “private equity put” or the new “Sovereign fund put”, the market psychology remains upbeat, and that is all there is to know.

Me no fretting the Chinese Bubble
Since the Chinese stock market has grabbed so many headlines recently, I thought I’d weigh in. First of all, recall that I wrote about $SSEC in early 2006 and was quite adamant that it had double bottomed at 1000 the year earlier. That was a time that no one wanted to touch Chinese stocks, particularly people in China. How much things have changed!

Now we have not shortage of people calling the bubble in China, while I don’t dispute the price rise has been nothing short of meteoric, I just want to point out that we call other people’s bubbles far more readily than our own. The P/E of the Chinese market has reached 50. I have been trying to find the P/E of the Nikkei at its peak, but that data has proved elusive. I have so far found one reference that the average bank stock P/E was 60 at the time! Triple digit P/Es were also common. This is not to say that the Chinese stock market has a lot further to go, but rather that it’s iffy to call a peak based on the P/E ratio, especially before it happens :-) IMO, the issue with China is the non-convertibility of its currency and consequent lack of outlet for people’s vast savings. The Chinese government is trying to curb excesses, most recently by increasing the stamp tax to 0.3% from 0.1%. The increase is insignificant but sends a very clear message that it intends to curb speculation. In the end, the Chinese government always has the option to release government shares which is what brought down the market in 2002-5. However, I believe it will not take that step lightly.

More pertinent to global investors is how a large drop in the Chinese stock market will impact the rest of the world, given the size and open nature of the Chinese economy. I believe that a large drop (say 30%) in the near future will not have much impact on even the domestic Chinese economy. It follows naturally that I believe commodity demand will remain robust.

Here’s my reasoning: Bubbles wreak havoc because it distorts price information which is the best feedback mechanism in a free economy for resource allocation. However, for mal-investments like dot com IPOs of 1999-2000 and Miami condos in 2005 to take hold, new investment decisions must be made based on the elevated prices and the bubble must persist for some time. Neither of these elements is present currently in China. First of all, most listed companies are state owned enterprises and listing is very much a political process. Consequently, small to medium sized non-state own enterprises that are the most vital parts of the economy cannot raise capital in the stock market. Secondly, if the bubble burst tomorrow, it would have lasted less than two years from the deeply oversold level of 1000 on the $SSEC. Not enough time to do big damage. Neither is there a mechanism to borrow against appreciated securities which is how many Japanese companies got into trouble. Without new issues, the stock market is nothing more than a wealth transfer mechanism. Spending may be curtailed by the “wealth effect”, but I don’t see a lasting effect on the economy if the bubble is to pop tomorrow.

The corollary of the above is that there’s a good chance the Chinese stock bubble will continue and cause more problem when it finally bursts. I also believe the bursting will be a positive for gold as people look for the next speculation target. One should never underestimate Chinese people’s propensity to gamble.

Right after my last post on the HUI, PMs obliged by moving sharply higher. (That was sorely needed after several not so accurate calls lately.) A very clear break out from the down trend can be observed in the HUI and many gold and silver stocks. There isn’t much to say except that the trend is now up and enjoy the ride. The critical levels to watch are again 369 and then 401.