Chinese Stock 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!

Today 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, and we may indeed have witnessed a 5th wave blow-off top. Nonetheless, it’s interesting to point out that we call other people’s bubbles far more readily than our own. According to Roubini, 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 :-) 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 clear message that it intends to curb speculation. In the end, the Chinese government always has the option to release official shares which was a big reason behind the market down turn in 2002-5 (see the first chart which was drawn in Jan 06). However, I believe it won’t be a step taken lightly. IMO, the issue with China is the non-convertibility of its currency and consequent lack of outlet for people’s vast savings.

Since few individual investors buy shares in Shanghai, the more pertinent question is how will a large drop in the Chinese stock market impact the rest of the world, given the size and open nature of the Chinese economy. I’m an optimist in that regard in that I believe a large drop tomorrow (say 30%) will not have much impact on even the domestic Chinese economy. It follows naturally that commodity should 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 the dot com’s of 1999-2000 and Miami condos in 2005 to take hold, new investment decisions must be made based on the elevated asset prices and the bubble must persist for some time. Neither of these elements is present 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. On top of that China has only a nascent VC sector and they are not rushing to give money away. Secondly, if the bubble burst tomorrow, it would have lasted less than two years from deeply oversold levels. Not enough time to do lasting damage. There isn’t a mechanism in China to borrow against appreciated securities which is how many Japanese companies got into trouble. After all, without new issues, a stock market is merely a wealth transfer mechanism. Those few individuals who mortgaged their house to speculate on shares may be hurt and the reverse “wealth effect” may curtailed some spending, but I don’t see a lasting effect on the economy as a whole.

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. There is a chance that 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.

As I finish this up Sunday evening, $SSEC is down over 7% to 3700 (roughly where the trend line is) at one point but has recovered to down only 4% or so. Recall that at the end of February, a 9+% drop there initiated a mini-crash in the rest of the world. Last Wednesday’s 6+% drop dragged down Asian and European markets across the board but US markets reversed higher nicely. Tonight, most Asian markets are up in the wake of the turmoil in Shanghai. It seems people are realizing the Chinese market for what it is: an isolated casino that matters little to its own economy, much less the rest of the world’s.

Another Look At The XAU Putcall Ratio

If I had to use a single word to describe the actions in gold/silver in recent days, it would have been “painful”. Many gold “gurus” rushed to forecast lower prices Tuesday’s $11 drop (at its lowest point). It behooves us to once again look at the XAU put/call ratio as a contrarian indicator.

I have previously called this a “mildly useful indicator”. Indeed, we have seen a number of spikes in this ratio to the range of 3-4. More often than not, such a spike is followed by 3-4 days of upside action. On Tuesday however, this ratio was above 5. The last spike of this magnitude occured at the low of this correction, where HUI bottomed at 275, some 15% lower than where it is now. As sentiment indicators go, the closer they are to the extremes, the more reliable they are; and the fear in gold investors was pretty palpable on Tuesday.

Recall the time analysis I posted on May 30. The HUI made a low of 317.7 on that very day. This past Wednesday, HUI dropped to as low as 317.81 before turning higher. I can’t predict if 317 will hold, but buying when fear is rampant has been a good recipe for this bull market in gold.

Last Week In Review

I’m still trying to make sense out of last the stock market decline last week and the bounce on Friday. Clearly global interest rates are on the rise; and the 10 year, in particular, took it on the chin. Its yield broke above a decade plus trend (link).

That China has announced its intention to not recycling its trade surplus into US treasuries as readily may be an indication of a long term shift in the treasury market (related link). Medium term, consumption in the US is on the wane due to declining mortgage equity withdrawal. The trade deficit is improving as a consequence. Paradoxically it also means our trading partners have less demand for treasuries. As a near term catalyst, Paul Kasriel of Northern Trust pointed to the most recent Fed custody holdings which showed a relatively large $12.5 billion reduction in the previous week.

Seeing that a rate cut may not arrive later this year in the best case (or the worst case depending on your point of view), and even if the Fed cuts, the yield curve can further steepen, only 20% is allocated to bonds in my re-worked asset allocation/passive portfolio. In addition to high quality, short term bond funds, I’m adding some floating rate, loan participation funds that I mentioned in passing in my article on closed end funds. Tim Middleton at MSN Money wrote about these types of mutual funds very recently. FFRHX (1 yr total return 7.16%) which was mentioned is actually the fund I own through my solo 401k account at Fidelity. I won’t go crazy with these funds since default risk goes hand in hand with high yields. So this is in effect a bet that higher rates now won’t plunge us into a severe recession.

Stock Market
I have iterated numerous times that I anticipate a housing-led slow down, but how the market will react is altogether another question. The daily chart on the S&P shows another short term trend line broken but the index took a stand at the 50 dma on Friday. In the weekly chart, the trend line is very much intact. The CBOE put/call ratio showed a big spike last Thursday, but we are still ways from the capitulatory levels seen in Feburary/March, so a little more down side is to be expected.

On the other hand, this market has shown too much resilience at the most critical junctures, so I’m not ready to go short yet. My current plan is to wait for the next leg down and see what kind of divergences, if any, reveal themselves.

I was far from the only one noticing the recent break out in PMs and PM stocks. Alas, money is not so easily made! The one characteristic of a bull market is to throw off as many people along the way as possible! After a couple days of reasonable relative strength, PM stocks went back to their old way of doubling to tripling losses in the general indices. As seen in the chart below, HUI briefly wend below the down trend line that it broke out from not too long ago. GDX, the ETF that tries to replicate HUI, has more clearly broken below its trend line.
I’m not letting these developments affect my core PM holdings which I still believe is in a secular bull market. But many johny-came-lately’s apparently has abandoned ship as GDX temporarily dipped below its recent low of $37.50 on Friday. Just to add another mildly useful indicator, the put/call ratio on XAU also spiked above 3 on Thursday which points to higher PM equity prices ahead.

I have consistently said that I’ll let the market tell me when it pays attention to evidence of a slowing economy. My ears perked up last Thursday, but as the rebound on Friday showed, we are not going anywhere in a straight line. Even if we go into a meaning correction/bear market from here, it’ll be a lengthy topping process. And if we do go to new highs, I intend to milk the last drop.