Ramblings of a Portfolio Manager or Even the Grinch Got Used to Pantookas and Wuzzles
What a week in the equity markets. The market took the triple onslaughts of Chinese monetary policy tightening, Scott Brown’s upsetting (to Democrats) victory, which produced the opposite of the expected effect by spurring Obama’s attempted face-saving attack in the form of plans to dismantle our world-leading financial system and a slew of rats, er Congressmen fleeing the sinking ship of State by backing away from the President by rejecting his preference for the reappointment of Federal Reserve Chairman, Ben Bernanke. As for the later case, when rats flee a sinking ship it is to save their own skins and they typically jump overboard rather than chewing a hole in the hull, hastening the demise of the doomed vessel. But Congressman, like rats it seems, cant read or understand spoken English and our boys on the hill are chewing big holes by ignoring the effect their defection from support of Bernanke would have on our already weakened economy and financial system and, by derivative, the equity markets. But at least they can comfort constituents on Main Street with “I didn’t support that guy who single-handedly brought down our financial system…Oh, so sorry your 401(k) is down 20% as a result.” At least our rats have their own safety net for the capsizing they will cause. Too bad for their constituents. Anyhow, the result of the Trifecta of bad news was the worst three day period in the markets since last February, a time when it wasn’t clear whether or not the Country was going into another great depression. The S&P 500 ended down 3.9% on the week and is now down 2.02% for the month while the Dow dropped 5.2% (552 points), ending down 2.45% for the year, and the Russell 2000 lost 4.53% ending down 1.29% for the year. Thanks, fellas, for working hard for the unemployed and looking out for the savings of the still employed.
Reality check. Is there reason to be concerned over the news and results last week? Is this the long-expected market correction? Our answer is no and no. First of all, everything that happened last week was the result of ever lurking but always surprising headline risk. Occasionally, politicians will say or do something dumb (maybe more than occasionally lately) and the markets extrapolate that information into a virtually certainty and immediately discount the expected results. That’s what markets do, but it doesn’t mean they are always accurate in their predictive power. In any market there is what is called “noise,” which is information that is market moving but non-impactful to underlying long-term fundamentals, and there are long-term policy or structural economic shifts, which are. We put last week solidly into the noise category.
Noise #1, China: funny how all the cynics who claim China is falsely inflating their economic numbers jumped on board with “told you so” when the Central Government tapped on the economic brakes last week. Let’s get this straight—the Chinese are purposely faking monetary contraction to lend credence to their faked economic expansion? Uh huh. Believe it or not, many of the Chinese Central Bankers were educated in Western Capitalist running dog business schools, studying past Fed actions, and understand the value of signaling. That is, it’s not so important what the “Fed” does as what it says in accomplishing its goals. We believe last week’s news release that the Chinese told banks to stop lending for the rest of month was more signaling than fact but, in any case, let’s put it in perspective—will two weeks (that’s all it is—not a permanent change) of reduced credit really derail the expansion of the worlds’ largest population? We don’t think so. Remember, our thesis is that the Central Government has 1.3 billion angry peasants to please. Putting the economy into decline is not going to cause them to put down their pitch forks and torches.
Noise #2, Banking reform: Even Geithner and Frank were surprised by the President’s announcement and subsequently tried to tone it down. In the former case, Turbo Tax Tim may be shown the door but Barney Frank is notoriously difficult to remove. Even that radical Congressman publicly declared the proposal too drastic and sought for a 3-5 year transition period, if the bill ever passes. We think the whole proposal dies an ignominious death either when we get a goodly portion of the democrats out of our Congress in November.or even earlier, when the incumbents get smart enough to realize that a consistent message of scapegoating does nothing for getting their constituents jobs and them votes.
Noise #3, Bernanke. This is a little more disturbing than the previous two as it is based on the unpredicability of panicky politicians. As Warren Buffet said, “let me know if Bernanke isn’t going to get reappointed so I can sell stocks.” We agree with him wholeheartedly. Blaming the prior administration for the current ills is a favorite tactic on Capital Hill and Bernanke is the scapegoat du jour, especially among Senators wishing to distance themselves from the flailing President. In point of fact, even if he is not reconfirmed, Bernanke will still sit on and control the FOMC, which sets rate policy decisions, so we will still have his wisdom and education to guide rate policy, but a weakened Fed is one without great credibility on Wall Street, which is not good. We believe that, ultimately, sanity will prevail and Bernanke will be reappointed (or for no other reason than they don’t have a viable alternative), but it will prove to be a volatile week ahead as rumors, sound bites and polls pollute the airways.
Bottom line: We think the 5% correction we just had is healthy and about as much to expect from the latest round of headlines. Volatility may remain elevated for a time but, ultimately, the markets will continue to grind higher as pending Congressional gridlock draws nearer and companies continue to report stronger than expected earnings.
Monday, January 25, 2010
Tuesday, January 19, 2010
Ramblings of a Portfolio Manager 1-19-2010
Hey Lloyd, will you autograph the dashboard of my Chrysler Sebring?
Einstein defined insanity as doing the same thing over and over expecting different results. If that former Nobel Laureate is correct, then a certain recent prize recipient may be overdue for a Rorschach and rubber room. One would think that, having witnessed the greatest slide in fist year/first-term popularity in history, our President might logically conclude that the public was tiring of punish the rich populist rhetoric, craving instead real solutions for the Nation’s stubbornly high unemployment rate, and modify his message. But dot connecting is a skill absent in Washington, DC these days and the White House response to news of an additional 85,000 jobs lost and a stated unemployment rate hovering around 10% (the true rate, which includes workers who have given up looking for a job, is estimated to be 17%) was the same old anger and outrage aimed at those fat cat bankers who, we are told, caused it all.
Last week’s anti-Wall Street message came in the form of a tax, er “Financial Crisis Responsibility Fee,” on large banks with more than $50 billion in assets (10 banks will bear 60% of the burden). The 10-year, $90 billion program is purported to pay back losses incurred under the TARP but it was introduced with the usual anti-wealth creation rhetoric, making its true intent suspect. Nothing about how this “fee” is going to spur loan growth or job creation. Also ignored was the fact that the big banks have all paid back all their TARP loans with interest (Accounting 101 tells us that means they incurred no losses), something the Union-controlled General Motors and Government –controlled Fannie Mae and Freddie Mac—all exempt from the fee--haven’t done. And no word on the vig Barney Frank and Chris Dodd will be assessed for their responsibility in the financial crisis. By week-end the populist harangue hit its latest zenith with Obama’s deal to exempt only union members from the “Cadillac Health Plan Tax” and a Democratic Michigan Representative’s pledge of support for the new bank fees because “Wall Street is solely responsible for all of Detroit’s woes.” Dang, we had forgotten that Goldman Sachs and Lehman Brothers were the saboteurs of the Pacer, Gremlin, Pinto and the remaining long list of Motown masterpieces. Anyhow, amidst all this political noise, its small wonder that the markets ended the week on a sour note.
That’s the “rambling” part. The real subject this week is interest rates. Since at least September the markets have been obsessed with the timing and magnitude of the Federal Reserve’s expected withdrawal of liquidity from the financial system. A key feature of the tapping on the brakes process will be a hike in short term rates—either the fed funds rate, the discount rate or both. The conventional wisdom is that higher rates are bad for the economy as they increase the cost of borrowing, reducing demand for loans while increasing the cost of doing business for virtually all companies, and they typically strengthen the dollar, slowing exports. We can’t argue with this economic theory and, of course, the whole point of a rate hike is indeed to slow down the economy. However, because we are in a political as well as economic Bizzaro Land these days, things don’t always follow the old playbooks. In fact, we posit that a hike in rates, at least in the initial phases, would be good for both the economy and equity markets. How so? To begin with, banks are currently dis-incentivized to lend. The ability to borrow at the Fed’s Discount Window at an effective rate of zero combined with the Government mandates to improve credit quality has motivated bankers to simply play the yield curve for profits. With long-term Treasuries yielding nearly 4% banks can earn a net interest spread comparable to the good old days with no default risk--so why make loans? A small hike in short-term borrowing costs to the banks, if it flattens the yield curve as it generally does, would give them more incentive to take risks in search of returns—i.e. make loans. Since the real problem now is the supply of lending, rather than demand, easier credit at this stage in the economic cycle would likely more than offset the braking effects of a small rise in short term rates.
What about the equity markets? It’s doubtful that the potential benefits to lending of higher rates would be immediately obvious to equity investors, however, since the markets are already discounting a long series of rate increases by the Fed beginning sometime this year (although that date is getting pushed out) the first rate hike, if it is small as expected (say 25bps) and accompanied by the proper “signaling” by the Fed would most likely spark a relief rally. After that, further fuel could come from the fact that retail investor money has been flowing out of equities and into fixed income investments for the last 16 months. A bump up in short term rates will knock down the value of short-term debt instruments, which might just be sufficient to scare that money out of the “safety” of T-bills and Treasuries and back into the equity markets. That’s a move, by the way, that could cause a virtuous cycle for some time as fixed income redemptions further depress the price of those securities while the flow into equities drives up stock prices, attracting more investment.
Of course, for the above scenarios to materialize, the Fed must properly signal its intent—e.g. “3 and done.” An open-ended series of rate hikes will eventually scare investors out of both asset classes (as well as real estate) and overshoot in their braking intent. As a student of the Great Depression, Bernanke is well aware of this. We just hope that the bout of insanity on Capitol Hill is temporary and that Congress will reappoint the Fed Chairman and start making noise about jobs rather than social engineering.
Einstein defined insanity as doing the same thing over and over expecting different results. If that former Nobel Laureate is correct, then a certain recent prize recipient may be overdue for a Rorschach and rubber room. One would think that, having witnessed the greatest slide in fist year/first-term popularity in history, our President might logically conclude that the public was tiring of punish the rich populist rhetoric, craving instead real solutions for the Nation’s stubbornly high unemployment rate, and modify his message. But dot connecting is a skill absent in Washington, DC these days and the White House response to news of an additional 85,000 jobs lost and a stated unemployment rate hovering around 10% (the true rate, which includes workers who have given up looking for a job, is estimated to be 17%) was the same old anger and outrage aimed at those fat cat bankers who, we are told, caused it all.
Last week’s anti-Wall Street message came in the form of a tax, er “Financial Crisis Responsibility Fee,” on large banks with more than $50 billion in assets (10 banks will bear 60% of the burden). The 10-year, $90 billion program is purported to pay back losses incurred under the TARP but it was introduced with the usual anti-wealth creation rhetoric, making its true intent suspect. Nothing about how this “fee” is going to spur loan growth or job creation. Also ignored was the fact that the big banks have all paid back all their TARP loans with interest (Accounting 101 tells us that means they incurred no losses), something the Union-controlled General Motors and Government –controlled Fannie Mae and Freddie Mac—all exempt from the fee--haven’t done. And no word on the vig Barney Frank and Chris Dodd will be assessed for their responsibility in the financial crisis. By week-end the populist harangue hit its latest zenith with Obama’s deal to exempt only union members from the “Cadillac Health Plan Tax” and a Democratic Michigan Representative’s pledge of support for the new bank fees because “Wall Street is solely responsible for all of Detroit’s woes.” Dang, we had forgotten that Goldman Sachs and Lehman Brothers were the saboteurs of the Pacer, Gremlin, Pinto and the remaining long list of Motown masterpieces. Anyhow, amidst all this political noise, its small wonder that the markets ended the week on a sour note.
That’s the “rambling” part. The real subject this week is interest rates. Since at least September the markets have been obsessed with the timing and magnitude of the Federal Reserve’s expected withdrawal of liquidity from the financial system. A key feature of the tapping on the brakes process will be a hike in short term rates—either the fed funds rate, the discount rate or both. The conventional wisdom is that higher rates are bad for the economy as they increase the cost of borrowing, reducing demand for loans while increasing the cost of doing business for virtually all companies, and they typically strengthen the dollar, slowing exports. We can’t argue with this economic theory and, of course, the whole point of a rate hike is indeed to slow down the economy. However, because we are in a political as well as economic Bizzaro Land these days, things don’t always follow the old playbooks. In fact, we posit that a hike in rates, at least in the initial phases, would be good for both the economy and equity markets. How so? To begin with, banks are currently dis-incentivized to lend. The ability to borrow at the Fed’s Discount Window at an effective rate of zero combined with the Government mandates to improve credit quality has motivated bankers to simply play the yield curve for profits. With long-term Treasuries yielding nearly 4% banks can earn a net interest spread comparable to the good old days with no default risk--so why make loans? A small hike in short-term borrowing costs to the banks, if it flattens the yield curve as it generally does, would give them more incentive to take risks in search of returns—i.e. make loans. Since the real problem now is the supply of lending, rather than demand, easier credit at this stage in the economic cycle would likely more than offset the braking effects of a small rise in short term rates.
What about the equity markets? It’s doubtful that the potential benefits to lending of higher rates would be immediately obvious to equity investors, however, since the markets are already discounting a long series of rate increases by the Fed beginning sometime this year (although that date is getting pushed out) the first rate hike, if it is small as expected (say 25bps) and accompanied by the proper “signaling” by the Fed would most likely spark a relief rally. After that, further fuel could come from the fact that retail investor money has been flowing out of equities and into fixed income investments for the last 16 months. A bump up in short term rates will knock down the value of short-term debt instruments, which might just be sufficient to scare that money out of the “safety” of T-bills and Treasuries and back into the equity markets. That’s a move, by the way, that could cause a virtuous cycle for some time as fixed income redemptions further depress the price of those securities while the flow into equities drives up stock prices, attracting more investment.
Of course, for the above scenarios to materialize, the Fed must properly signal its intent—e.g. “3 and done.” An open-ended series of rate hikes will eventually scare investors out of both asset classes (as well as real estate) and overshoot in their braking intent. As a student of the Great Depression, Bernanke is well aware of this. We just hope that the bout of insanity on Capitol Hill is temporary and that Congress will reappoint the Fed Chairman and start making noise about jobs rather than social engineering.
Monday, January 11, 2010
Ramblings of a Portfolio Manager 1-11-2010
Fair is Foul and Foul is Fair
--Macbeth
The old saying on Wall Street is “as goes January so goes the year.” It’s a quaint little scrap of urban legend that suggests the first week of trading in the stock market—the Dow Jones Industrial Average—foreshadows the remainder of the year. Over the years stock traders, ever an impatient lot, have further distilled the adage into “as goes the first week of January, so goes January” thus avoiding the wait until the 31st to make their asset allocation decisions. Not to be outdone other, equally superstitious, traders have added the Super Bowl Indicator, which suggests a correlation between the winner of the big game and the performance of the equity markets (Dow) in that calendar year (old NFL team wins are good, former AFL team victories are bad). While both myths are good for a chuckle, there is a surprising correlation between them and Dow performance. The Superbowl Indicator has a better than 88% accuracy rate over its life while the so-called January Barometer has demonstrated predictive power 73% of the time when the indicator points up. It’s all spurious, of course, but it gives the tooth fairy believers among us in the markets something to which to look forward during the bleak winter weeks. But we digress.
The US equity markets got a good start to the new year last week. The Dow rose 1.82% while the S&P 500 gained 2.74% and the Russell 2000 Index of small cap stocks bested them all at +3.08%, giving believers in the January Barometer something to cheer. What was remarkable to some, however, is that these gains came amid the release of mixed to weak economic data: Construction Spending kicked off the week coming in slightly worse than expected, down 0.6%, followed by the ISM Index, which was slightly better at 1.1% vs. a forecast of 0.5%. Pending Home Sales were a disaster, down 16% vs. a +2.0% forecast but the 800 lb. gorilla broke the scales on Friday when Nonfarm Payrolls were reported at -85,000 vs. a forecast of flat and some market expectations of a rise. While most of the market gains occurred on Monday, the first trading day of the year, the markets failed to give it back during the rest of the week and actually tacked on slight gains over the remaining trading days even in the face of the weak economic news, especially on Friday. To the market skeptics this behavior was absurd; to us it was predictable.
Market bears have decried the rally since it began on March 9th and they’ve thrown every known investment cliché at it—from “too far too fast” to “not supported by fundamentals” to a cornucopia of chart-speak we don’t understand so will not quote here. Having failed to receive their expected revisit of the Dow to the 6000 region, these same skeptics are now calling for the end to come when the Federal Reserve begins to withdraw liquidity and hike rates, which was expected to occur later this year. Here we cannot disagree with them. While we believe much of the markets’ rise since March has been the result of them doing their job as discounting mechanisms, anticipating the economic rebound we are now seeing, much still has been liquidity-driven. An effective short-term interest rate of zero has made the equity markets look “cheap” in many investment models--not to mention what that implied yield curve has done to bank earnings--and the result has been as remarkable as it has been predictable. Anyone who doubts the rate effect on the markets need only look at the inverse correlation between the dollar and markets over the last year or, more recently, the sideways action of equities amid the increasing belief that the Fed will begin to raise rates sometime in mid-2010. In fact, we were prepared, earlier this week, to call this piece “Sell in May and Go Away,” suggesting that if most market participants expected a June-July rate hike, then the time to get out of equities would be months earlier. Friday changed all that. The weak jobs numbers, we believe, have pushed out market expectations of a rate rise to later in the year. Before the report PIMCO’s Bill Gross was calling for no rate hike at all this year and few believed him—now, many do.
So what do we expect now, as we head into earnings season? Perversely, we believe that for individual equities, bad news will continue be seen as negative and good news good, while for the equity markets as a whole, bad news—in the form of weak economic data--will be positive overall as it will push further out the expected date the Fed will have to take back the proverbial “punch bowl.” Add on top the cynical optimists (like us) who believe that continued weak jobs data will spur the White House into releasing more Fiscal stimulus programs ahead of the mid-term elections and you have a recipe for continued market gains amid lackluster economic reports. Last week we poked fun at investment managers who call each year for a “market of stocks” versus a “stock market” but for the upcoming quarter, at least, that just might be what we will see.
--Macbeth
The old saying on Wall Street is “as goes January so goes the year.” It’s a quaint little scrap of urban legend that suggests the first week of trading in the stock market—the Dow Jones Industrial Average—foreshadows the remainder of the year. Over the years stock traders, ever an impatient lot, have further distilled the adage into “as goes the first week of January, so goes January” thus avoiding the wait until the 31st to make their asset allocation decisions. Not to be outdone other, equally superstitious, traders have added the Super Bowl Indicator, which suggests a correlation between the winner of the big game and the performance of the equity markets (Dow) in that calendar year (old NFL team wins are good, former AFL team victories are bad). While both myths are good for a chuckle, there is a surprising correlation between them and Dow performance. The Superbowl Indicator has a better than 88% accuracy rate over its life while the so-called January Barometer has demonstrated predictive power 73% of the time when the indicator points up. It’s all spurious, of course, but it gives the tooth fairy believers among us in the markets something to which to look forward during the bleak winter weeks. But we digress.
The US equity markets got a good start to the new year last week. The Dow rose 1.82% while the S&P 500 gained 2.74% and the Russell 2000 Index of small cap stocks bested them all at +3.08%, giving believers in the January Barometer something to cheer. What was remarkable to some, however, is that these gains came amid the release of mixed to weak economic data: Construction Spending kicked off the week coming in slightly worse than expected, down 0.6%, followed by the ISM Index, which was slightly better at 1.1% vs. a forecast of 0.5%. Pending Home Sales were a disaster, down 16% vs. a +2.0% forecast but the 800 lb. gorilla broke the scales on Friday when Nonfarm Payrolls were reported at -85,000 vs. a forecast of flat and some market expectations of a rise. While most of the market gains occurred on Monday, the first trading day of the year, the markets failed to give it back during the rest of the week and actually tacked on slight gains over the remaining trading days even in the face of the weak economic news, especially on Friday. To the market skeptics this behavior was absurd; to us it was predictable.
Market bears have decried the rally since it began on March 9th and they’ve thrown every known investment cliché at it—from “too far too fast” to “not supported by fundamentals” to a cornucopia of chart-speak we don’t understand so will not quote here. Having failed to receive their expected revisit of the Dow to the 6000 region, these same skeptics are now calling for the end to come when the Federal Reserve begins to withdraw liquidity and hike rates, which was expected to occur later this year. Here we cannot disagree with them. While we believe much of the markets’ rise since March has been the result of them doing their job as discounting mechanisms, anticipating the economic rebound we are now seeing, much still has been liquidity-driven. An effective short-term interest rate of zero has made the equity markets look “cheap” in many investment models--not to mention what that implied yield curve has done to bank earnings--and the result has been as remarkable as it has been predictable. Anyone who doubts the rate effect on the markets need only look at the inverse correlation between the dollar and markets over the last year or, more recently, the sideways action of equities amid the increasing belief that the Fed will begin to raise rates sometime in mid-2010. In fact, we were prepared, earlier this week, to call this piece “Sell in May and Go Away,” suggesting that if most market participants expected a June-July rate hike, then the time to get out of equities would be months earlier. Friday changed all that. The weak jobs numbers, we believe, have pushed out market expectations of a rate rise to later in the year. Before the report PIMCO’s Bill Gross was calling for no rate hike at all this year and few believed him—now, many do.
So what do we expect now, as we head into earnings season? Perversely, we believe that for individual equities, bad news will continue be seen as negative and good news good, while for the equity markets as a whole, bad news—in the form of weak economic data--will be positive overall as it will push further out the expected date the Fed will have to take back the proverbial “punch bowl.” Add on top the cynical optimists (like us) who believe that continued weak jobs data will spur the White House into releasing more Fiscal stimulus programs ahead of the mid-term elections and you have a recipe for continued market gains amid lackluster economic reports. Last week we poked fun at investment managers who call each year for a “market of stocks” versus a “stock market” but for the upcoming quarter, at least, that just might be what we will see.
Monday, January 4, 2010
Ramblings of a Portfolio Manager 1-4-2009
Will China Do it Again?
It’s just about axiomatic on Wall Street that the top-performing market, sector, or asset class from one year seldom retains that title over the course of the next twelve months. Notwithstanding the marketing materials from the momentum or “trend is your friend” style of investing crowd, our research shows the old adage largely holds true when one looks within a particular geographic market. Here in the US one needs only to look at the tech bubble and subsequent wreck of 1999-2000, the real estate and financial services boom and bust of 1989- 1990 and more recently 2006-2007, and the commodities run over 2007-2008. There are many more examples and they all share the same basic life cycle: a catalyst—e.g. interest rates, currency exchange rates, disruptive product innovation, mania, etc., which starts the performance trend--a reaction, which is generally a big run up in prices during the latter stage of which the term “this time it’s different” is often heard--followed by an inhibitor –Central Bank actions, aging product life cycle, valuation concerns, someone standing up and yelling “hey, he’s just a big cockroach” (as in the old Far Side cartoon), which cools the trend or pricks the bubble as it were.
There has been much hand wringing over China, its stock market and economy of late. Many of the pessimistic charges levied against the US market and economy have similarly been aimed at China, often by the same cynics. The Chinese Shanghai Composite index rose over 75% in 2009 and Chinese GDP grew at a rate somewhere north of 8% according to most economists. The GDP growth rate compares to 11.4% and 9.6% in 2007 and 2008. The term “too far too fast” is beginning to be applied to the Chinese stock market while “bubble economy” or “stimulus dependent” are phrases one often hears regarding the Country’s economy. Sound familiar? Of course there is the whole cadre (that’s what Mao would have called them just prior to having them shot) who simply claim that China fakes the economic numbers and that the entire market run-up is a sham.
We can’t argue with the fact that the trend in China’s GDP is for slower growth each year—even we agree with the proverb that “trees don’t grow to the sky” and eventually the law of large numbers takes over—but we take issue with the fact that China is in a falsified or stimulus-induced bubble destined to soon burst. As with the US, government actions are indeed driving the economy in the short term. The 4.0 billion Yuan stimulus package passed by the Chinese Central Government last year is most certainly behind the Country’s impressive growth rate amid a slumping world economy. The State controlled banks kicked off the growth with a lending spree that produced a 30% jump in the Chinese money supply (M2) and this was followed by the spending package aimed mostly at infrastructure projects in the Country. Like the US, together these monetary and fiscal moves have been the catalysts that produced the desired jump-start effect to GDP growth and the stock market has followed. Unlike the US, however, we see no reason for the Chinese Central Government to yank the punch bowl any time soon, either through higher interest rates, spending reduction or higher taxes.
As we write this the Shanghai index has gotten of to a rocky start to 2010 on fears that the Government will cut stimulus spending and remove liquidity earlier than previously expected, cooling growth. Again, sound familiar? At last count there were something like 1.3 billion Chinese living in China. Metaphorically, that is certainly enough that if they all jumped off a chair at the same time, the Earth would indeed move—which means practically that they wield significant “weight” in the World economy. The nominal per-capita GDP of these masses (about $3200 n 2008 according to the World Bank) places them in the lower middle class by world standards yet collectively they comprise the World’s second largest economy after our own. It’s human nature that #2 seeks to emulate or surpass #1 which means all these Chinese want the same or better standard of living that we have—cell phones, cars, televisions, 17 flavors of potato chips, etc--.and that they have a long way to go to get it. And even though they don’t have the same voting or freedom of speech rights as we, they are quicker to carry pitchforks and torches when they don’t get what they want. The Chinese Government, in our opinion, has 1.3 billion reasons not to take its foot off the accelerator anytime soon and unlike the US, with no massive debt balance to cause them concern over spending or contemplate raising taxes to pay for it all, they have the flexibility to keep that foot down. In addition, China is keeping the value of it’s the Yuan pegged to the US dollar at very low levels with no incentive to raise the exchange rate ( due to all the money we owe them—they ain’t stupid, you know). With the greenback depreciating at a record pace over the last year, the trade-weighted value of Yuan is also declining, making Chinese goods cheaper to recovering consumers worldwide. That will spur exports, driving manufacturing and in turn keeping the economic engine running when liquidity is eventually withdrawn. As the Chinese economy begins to demonstrate that it can grow on its own two feet, we expect that its stock market will follow in lock-step. So even the Shanghai was fine in 2009, we can see it do it all again in 2010.
It’s just about axiomatic on Wall Street that the top-performing market, sector, or asset class from one year seldom retains that title over the course of the next twelve months. Notwithstanding the marketing materials from the momentum or “trend is your friend” style of investing crowd, our research shows the old adage largely holds true when one looks within a particular geographic market. Here in the US one needs only to look at the tech bubble and subsequent wreck of 1999-2000, the real estate and financial services boom and bust of 1989- 1990 and more recently 2006-2007, and the commodities run over 2007-2008. There are many more examples and they all share the same basic life cycle: a catalyst—e.g. interest rates, currency exchange rates, disruptive product innovation, mania, etc., which starts the performance trend--a reaction, which is generally a big run up in prices during the latter stage of which the term “this time it’s different” is often heard--followed by an inhibitor –Central Bank actions, aging product life cycle, valuation concerns, someone standing up and yelling “hey, he’s just a big cockroach” (as in the old Far Side cartoon), which cools the trend or pricks the bubble as it were.
There has been much hand wringing over China, its stock market and economy of late. Many of the pessimistic charges levied against the US market and economy have similarly been aimed at China, often by the same cynics. The Chinese Shanghai Composite index rose over 75% in 2009 and Chinese GDP grew at a rate somewhere north of 8% according to most economists. The GDP growth rate compares to 11.4% and 9.6% in 2007 and 2008. The term “too far too fast” is beginning to be applied to the Chinese stock market while “bubble economy” or “stimulus dependent” are phrases one often hears regarding the Country’s economy. Sound familiar? Of course there is the whole cadre (that’s what Mao would have called them just prior to having them shot) who simply claim that China fakes the economic numbers and that the entire market run-up is a sham.
We can’t argue with the fact that the trend in China’s GDP is for slower growth each year—even we agree with the proverb that “trees don’t grow to the sky” and eventually the law of large numbers takes over—but we take issue with the fact that China is in a falsified or stimulus-induced bubble destined to soon burst. As with the US, government actions are indeed driving the economy in the short term. The 4.0 billion Yuan stimulus package passed by the Chinese Central Government last year is most certainly behind the Country’s impressive growth rate amid a slumping world economy. The State controlled banks kicked off the growth with a lending spree that produced a 30% jump in the Chinese money supply (M2) and this was followed by the spending package aimed mostly at infrastructure projects in the Country. Like the US, together these monetary and fiscal moves have been the catalysts that produced the desired jump-start effect to GDP growth and the stock market has followed. Unlike the US, however, we see no reason for the Chinese Central Government to yank the punch bowl any time soon, either through higher interest rates, spending reduction or higher taxes.
As we write this the Shanghai index has gotten of to a rocky start to 2010 on fears that the Government will cut stimulus spending and remove liquidity earlier than previously expected, cooling growth. Again, sound familiar? At last count there were something like 1.3 billion Chinese living in China. Metaphorically, that is certainly enough that if they all jumped off a chair at the same time, the Earth would indeed move—which means practically that they wield significant “weight” in the World economy. The nominal per-capita GDP of these masses (about $3200 n 2008 according to the World Bank) places them in the lower middle class by world standards yet collectively they comprise the World’s second largest economy after our own. It’s human nature that #2 seeks to emulate or surpass #1 which means all these Chinese want the same or better standard of living that we have—cell phones, cars, televisions, 17 flavors of potato chips, etc--.and that they have a long way to go to get it. And even though they don’t have the same voting or freedom of speech rights as we, they are quicker to carry pitchforks and torches when they don’t get what they want. The Chinese Government, in our opinion, has 1.3 billion reasons not to take its foot off the accelerator anytime soon and unlike the US, with no massive debt balance to cause them concern over spending or contemplate raising taxes to pay for it all, they have the flexibility to keep that foot down. In addition, China is keeping the value of it’s the Yuan pegged to the US dollar at very low levels with no incentive to raise the exchange rate ( due to all the money we owe them—they ain’t stupid, you know). With the greenback depreciating at a record pace over the last year, the trade-weighted value of Yuan is also declining, making Chinese goods cheaper to recovering consumers worldwide. That will spur exports, driving manufacturing and in turn keeping the economic engine running when liquidity is eventually withdrawn. As the Chinese economy begins to demonstrate that it can grow on its own two feet, we expect that its stock market will follow in lock-step. So even the Shanghai was fine in 2009, we can see it do it all again in 2010.
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