Despite sluggish domestic stock performance in 2007 China stock investors have a good reason to cheer. The Shanghai Composite Index climbed 96.7 percent on the year, making it the world’s best performing major bourse in 2007. Chinese companies listed in Hong Kong were just as strong, shooting up 59 percent followed closely by the broader Hang Seng Index. Hong Kong  blue chips rose 39 percent in 2007, representing its best annual rise since 1999.  All major Chinese indices ended 2007 on a high note, prompting questions how long the China bull will run.

We are of a view that risk is more on the upside than the downside in 2008. Here is why. 

· Analysts continue to be cautiously optimistic about Asian economies based on the performance of economic engines running full-tilt in China and India.

· Looking at China in particular, economic conditions look very strong with ample liquidity, huge current account surplus, and minimal exposure to U.S. housing related trouble. Just to highlight the strength of the economy, consider this: China’s gross domestic product growth will probably hit 11.5 percent in 2007 and dip just under 11 percent in 2008. This puts China comfortably on course to rack up its fifth consecutive year of double-digit growth. Additionally, 2007 trade surplus will likely to come close to $260 billion, topping last year’s record. As a result, we argue that China looks to have the capacity to offset a slow down in the U.S., with investment spending both at corporate and government levels. With $1.3 trillion foreign reserve in coffers, China is in a good position to increase spending if necessary to offset an exports-led slow down. Higher spending is likely to have positive impact on banks, real estate and consumer goods. More directly, it should also be positive for construction-related materials.

· We understand that Wall Street has a tremendous weight on global and in particular on Chinese equities and will continue to have. Having said that China stock investors have to keep a close eye on the Street particularly in the first half of 2008. However there are more and more signs that China has been shifting emphasis towards domestic consumption and as a result Chinese companies are expected to report strong corporate profits despite weakness in western stock markets, fueling a potentially strong stock performance in the second half of 2008 and beyond.

· It is a fair assumption that the Chinese yuan will continue to appreciate against the greenback in 2008. If so, currency change will keep boosting dollar denominated stock prices of Chinese ADRs. The underlying fundamental for a stronger yuan is that inflation has risen to an 11-year high in China and a stronger yuan can help contain inflation risks from the booming economy. Rising global commodity prices, as a result of the weakening dollar, create inflationary pressures for China too, a trend that is likely to extend well into 2008. Curbing inflation is number one priority in China and as such, we expect the yuan to appreciate faster in 2008. Although a stronger yuan might hit some Chinese exporters, the government is in a position to give them financial support and encourage them to shift from export-oriented industries into the domestic sector. Another good reason for China to speed up the yuan appreciation is problems associated with excess liquidity. If China will be successful tightening its monetary policy, to curb inflation and to keep the economy from overheating, it will also mean reducing liquidity which in turn means addressing the ballooning trade surplus.

· Another assumption we make is that excess money from the mainland will continue to flow to foreign capital markets, primarily to Hong Kong. If so, U.S. listed ADRs that automatically mirror Hong Kong stock prices will soar, boosted by strong money flows from the mainland. Beijing has been flirting with the idea to let Chinese individuals buy directly stock in Hong Kong. Excess liquidity resulting from the rising trade imbalance is the root cause of surging inflation where capital outflows to Hong Kong could help relax pressure and help balance international payments. China’s currency regulators unveiled plans for such a program at the end of August. Hong Kong-listed shares soared following news of the plan, dubbed “through train”, but have since pulled back in raising concerns about Beijing’s commitment to follow through.

· We have seen a very strong initial public offering  activity in Shanghai in 2007 with a lot of fuel still in the pipeline. Few of the large cap NYSE-Hong Kong cross-listed blue chips are waiting to get listed on the Shanghai Stock Exchange in addition such  as CNOOC LTD and China Mobile. For the first time since its launch in 1990,  Shanghai became the first stock market of choice for  medium and small cap  Chinese companies. Buoyant IPO activity is always followed by strong money flows, giving broader Chinese markets additional boost in 2008. IPO on the Shanghai Stock Exchange raised an estimated 418 billion yuan (US$57.2 billion) in the first 11 months of 2007. This is up from about 140 billion yuan a year earlier, making Shanghai the world’s biggest market for IPO in 2007. Now let’s add Hong Kong’s HK$287 billion (US$36.8 billion) IPO activity in the first 11 months of 2007 to that and it is clear that Chinese stock markets well surpassed any global markets in terms of IPO activity in the year of 2007. Regarding 2008, Chinese companies are set to raise ~$100 billion in 2008 through IPOs.

The stage looks to be set for a record year from Chinese stocks in 2008. Except for one thing: there is no one to know the depth of the mortgage related credit crisis and its impact on the U.S. and global economies.

Still, we are in a better shape now than in early August when Jim Cramer went ballistic on live TV. At least we know by now what the problem is and the FED started to take action accordingly. We all know that interest rate cuts mean a weaker dollar and higher inflation which can not go on indefinitely. However the capital markets needed action and they seem to have regained some of the confidence as a result. We are aware that stock markets are prone to be more sensitive to negative news than to positive ones and as such 2008 will be a nerve racking year for domestic investors. But overall we don’t believe in a doom scenario. And if the U.S. economy holds up, China should do great in 2008.

If history is any good at predicting the future, NYSE listed Chinese ADRs are the way to go in 2008. As the following chart reveals, NYSE listed Chinese ADRs rose 57.1 percent on average in 2007 handsomely beating their NASDAQ counterparts.

Our long time subscribers can testify how many times we have argued that NASDAQ listed Chinese ADRs offer higher return in general but at a price of higher risk. And under current market conditions when investors have low risk tolerance, bearing high risk stocks doesn’t pay off. One of the problem with NASDAQ listed Chinese ADRs is their relatively high P/E ratio as we have highlighted in the December and June Newsletters.

Besides valuation concerns, NASDAQ names tend to be more volatile as the tables on the next page testify. Both the best and the worst stocks in 2007 came from the NASDAQ universe with China Finance Online’s (JRJC)  and UTStartcom Inc.’s (UTSI) return of 339.8% and –68.9%, respectively.

Another reason Chinese NYSE names were a better choice for 2007 is that their stock performance was much more universal in 2007 than that of the NASDAQ. While winners, stocks that made you money in 2007, outnumbered losers by 17 to 3  on the NYSE, NASDAQ listed names came out to 11 to 11 on the same scale. In other words, you had over an 85 percent chance to pick a winner stock on the NYSE while NASDAQ names gave you only a 50-50 percent chance.

Looking forward into 2008, we don’t see much change in the first half of the year. If so, NYSE listed Chinese names are our first choice with a focus on consumer staples, energy, and construction related materials.

From this respect, quality Chinese solar companies are likely to continue doing well but again, not all stocks offer sound investment opportunities.  We like Suntech Power Holdings Co. Ltd. (STP) as a 12 page long fundamental analysis posted on the Chinavestor.com website under “Stock Analysis” folder testifies.

Despite current pullback, PetroChina (PTR) is our primary choice among Chinese oil companies. Sinopec (SNP) is likely to receive a year-end tax credit for its accumulated losses on the refining arm and get a boost for a short time however Sinopec needs crude prices be under $70 just to break even on refining. CNOOC Ltd. ( CEO), China’s offshore specialist, is a dark horse at this point however high crude prices definitely benefit the company.

Talking about energy, we continue to like Yanzhou Coal (YZC). China became a net coal importer in 2007 for the first time as coal miners seem to find it difficult to catch up with demand.

Chinese airliners had a great year in 2007, something that we don’t expect to be repeated in 2008. Most of the exuberance will be over in January when China Eastern (CEA) shareholders most likely will approve the strategic partnership with Singapore Airlines. We expect China Life Insurance (LFC) to be volatile in the first half of 2008 as she is somewhat exposed to the performance of the Shanghai Stock Exchange. LFC may be a better choice in the second half of the year.

Regarding NASDAQ names, we continue to like Baidu.com (BIDU), Ctrip.com (CTRP), and Focus Media (FMCN).

For updates on stock recommendation, please follow closely portfolios on page 5 and weekly stock updates. Wish you successful investing in 2008!

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