Ramblings of a Portfolio Manager or Is China History? A good technician will tell you that the trend is your friend…until, of course, it isn’t. That helpful advice is now being delivered in shiploads with respect to the Chinese stock market. Now down over 23% from its July peak, the Shanghai Index took a nearly 7% hit on Monday. Smelling blood, the technicians and other skeptics came out in droves to proclaim all sorts of doomsday scenarios both for the Shanghai as well as the Dow, complete with detailed sets of new support and resistance levels. We note more than a few of these chartists enjoyed the ride up and now, having missed calling the top, are frenzy-feeding on the blood scent of a chart that has rolled over.
Forgetting the entrail readers for a moment, the real issue upon which to focus is whether the direction of the Shanghai has any direct relationship to the state of the underlying Chinese economy and if the well-used but largely debunked phrase of decoupling can be (hopefully) applied to the US market. As always, the answer to the first question largely dictates the answer to the second. A brief background is in order: The Chinese economy went into a “slump” before the US officially hit the skids. “Slump,” however, is a relative term. The big run in Chinese equities came to an end on October 9th, 2007, after a nearly 5-fold rise in a little over 20 months. Much of the rise was declared to be at the time, and in restrospect truly was, based on speculation by domestic retail investors. Of course, those speculators got started somewhere and the massive Chinese infrastructure build ahead of the Olympics certainly gave them a reason. The ensuing double-digit GDP growth only fanned the speculative flames. When the torch went out and the country was no longer in the global spotlight, the window-dressing spending stopped, things softened and the market followed accordingly. 11 months later our economy experienced its AIG/Lehman hangover and the Shanghai continued its slide along with the US markets.
Hind-sight is always 20/20 and looking back, it is easy to see that the Chinese market was overly optimistic about the long-term growth prospects of the underlying economy during the bull run of 2005-2007 (remember the NASDAQ in 1999??). But hindsight also tells us that Chinese stocks got overly pessimistic late last year as our economy headed into the toilet. How can we say that? Well, unlike the US, China has vast currency reserves, no crippling national debt, a government body that can act swiftly without endless partisan and special interest debate (they shoot dissenters you know) and a strong motivation to keep the economic boom intact (farmers rioting in the streets doesn’t play well on the BBC). And the Chinese Government put all these advantages to work in a much more stimulative set of initiatives than our borrow, spend on pork and tax program, with much more favorable expected outcomes. So much of this year’s climb in the Shanghai, in our humble opinion, has been warranted. But did Chinese investors get overly optimistic once again? Probably. Trees don’t grow to the sky, is a favorite saying of old-timers on Wall Street., meaning that no market goes straight up forever. So, now that we have a fairly sizeable sell-off in Chinese equities, are they now overly pessimistic in their assessment of the future state of the economy? Most likely. The Chinese Government, as we mentioned, has the means and motivation to keep the spending tap open and there is no reason to suspect that they will turn it off any time soon (they’ve got no Milton Friedman-types sounding inflation alarm bells over there). So the Chinese engine of growth, we believe, still has at least ¾ a tank full of gas. What about the relationship to our markets? Here again, history can be a guide. When China tanked in 2007, the pundits decried a decoupling of our economies and markets. Didn’t happen. When the Chinese economy and markets started to turn ahead of those in the US earlier this year, the same pundits once again rang the decoupling bell. Didn’t happen. And in the early stages of the Chinese market sell-off in July/August, the optimistic “decouplers” came out once again. Not looking like that is going to hold true either. So, if, as we believe, the dip in Chinese equities is the pause that refreshes and has more to do with investor sentiment than the actual future of Chinese GDP growth, then we humbly suggest taking advantage of the decoupling myth, when it proves itself as such, over the next few months.
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