Sunday, June 03, 2007

Could China’s Bubble Last Longer than Expected?

``The art of central banking is too important to be left to bankers.”-William Pesek, Bloomberg Analyst

And for those insisting that China’s global markets have set the pace for Asia’s market, this we have argued against previously on our February 26 to March 2 edition (see The Blame is on China’s “Shanghai Surprise”, But....); we believe that China’s basically closed capital account and very limited markets to both foreign investors as well as to domestic retail investors (in spite of the blow off numbers) will have less impact to global markets than the rest of the playing field with relatively open capital flows structure.

According to Bloomberg’s Scott Lanman and Simon Kennedy (emphasis mine), ``Total stock holdings in China account for just 25 percent of domestic wealth, and in Asia only Indonesia has a smaller market capitalization than China's 60 percent of GDP….China has capped foreign investment at an aggregate $10 billion in the yuan-denominated ``A'' shares, less than the market value of about 700 U.S.-listed companies.”

This week, China’s stock markets fell the most as its Shanghai index slumped by 4.28% while its Shenzhen index cratered by 8.62% in the face of Asian soaring markets.

If China’s market supposedly LED most of Asia then the recent tremors instigated anew by the government repeated attempts to rein in the parabolic or near vertical run should have caused an equivalent selloff elsewhere, however except for a few seemingly unrelated but insignificant degree of declines in Sri Lanka (-1.32%), Vietnam (-1.12%) and New Zealand (-.2), such China-led premise has ben proven to be a fallacy.

Is it the end of the run for China? We don’t think so. While we share former FED Chief Alan Greenspan or Hong Kong magnate Li Ka Shing’s concerns that China could be due for “dramatic contractions”, we doubt if this would be the end of the bubble.

First and foremost, we do agree that China’s market is in a bubble; when maids quit their jobs (10% of maids in Shanghai!!...according to a Bloomberg report) to do stocks it is definitely signs of a bubble.

However, we don’t think bubbles end soon enough, simply because markets can ever remain so irrational against anyone’s expectation, including Mr. Greenspan or Mr. Li Ka Shing.

Another is that government’s repeated attempt to quash the bubble seems to only intensify buying actions. Each decline has been seen as rather a buying opportunity than the end of the streak. Our view is that bubbles usually collapse by their very own weight.

Most importantly, China’s bubbles are symptomatic of the global inflationary syndrome we have been talking about. Excess US dollars or revenues from exports and investments have to be redeemed by printing local “Yuan/remembi” currency. But since China’s bond markets are yet underdeveloped, “sterilization” or open market operations by the government to absorb surplus money by way of sale of domestic bonds have been inadequate; hence surplus liquidity has permeated its way into China’s stock market.

In addition, the country’s closed capital account and heavily regulated markets have limited the options of the nation’s capability to allocate into other forms of investments. Unless China decides to opt out of symbiotic recycling its excess forex reserves into US treasuries vis-à-vis export revenues, we are likely to see a continuity of this phenomenon of liquidity boosted stock markets in China.

In the future, contrary to most expectations, it is even possible that the US dollar could gain against the China’s currency as the real rate of money supply growth has been more than that of the US.

Finally bubbles don’t usually end with 400% gains from the bottom even at a very short time span. We have previously seen the gains of the Nikkei and of US treasuries as much as we have seen the past the full cycle of the Phisix.

Figure 3: Bloomberg: Saudi’s Tadawul Index

In figure 3, as I have previously shown you, Saudi’s Tadawul Index raced from 2,400 to a zenith of 20,350 in a period of about three years or for about 7.5 times return before imploding.

Today, from its pinnacle to a low of 7,050, Saudi’s Tadawul is off by about 65% from its high.

In Bear market cycles, values lose about 80% to 90% from its peak before finding a bottom. In the dimension of Saudi Tadawul this translates to a probable bottom at around the 4,000-5,000 area. Although if present consolidation would be able to base form for a longer timeframe, say one year, possibly this area could also mark as a bottom. But it is too early to make a call.

Our aim is to show how a full market cycle unravels.

Figure 4: Bloomberg: China’s Shenzhen Index

Similarly in Figure 4 China’s Shenzhen index has zoomed from about 230 up to a recent high of 1,290 for an equivalent return of 4.6 times in a very rapid two years frame.

While such vertical action can lead to extremely wild swings, given the secular performances of the other asset classes, this tell us that Shenzhen Index could reach somewhere 1,800 to 2,000 for its “a blow off top” which follows the “dramatic correction” which our gurus are looking for (back to 500???).

Of course, the financial markets do not operate on the spectrum of rocket science; hence we work on guess estimates and probabilities.

Over at the Phisix, the momentum has clearly favored the bulls for the moment. The gains which we have previously defined as a “rising tide lifts all boats” have been punctuated as advancers run roughshod on the decliners. We had two days where bulls were all too dominant with 111-6 on Thursday and 90-25 on Friday.





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