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Europe holds the key for Chinese stocks in July, too!

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Euro_2 Chinavestor (July 2012)  There was a noticeable divergence between world markets and stock markets in China for June. The Dow Jones Industrial Average (INDEXDJX:.DJI) rose 3.9% for June making it the best month of the year. Not only was June a record month but it ended on a high note. The Dow surged 278 points on the last day of June while the NASDAQ recorded its best day of the year on June 29. Similarly to U.S. indexes, the Hang Seng Index (INDEXHANGSENG;.HSI) made a strong comeback for the month along with the China ADR Index, measuring the performance of Chinese stocks listed in the U.S. In contrast to that stands mainland China, where two months, May and June, were enough to erase most of earlier gains for 2012. The Shanghai Composite Index (SHA:000001) fell 6.2% in June, making it the worst performing major stock index in Asia. Reason for such a decline is that investors did’t find evidence that the government did enough by loosening policy to stem economic slowdown. Europe not only makes up 18 percent of China’s overseas shipments, but is the largest trading partner of the nation as well. A recession in Europe hits China’s export oriented economy directly and as such is a real cause of concern for Mainland investors. They all seem to agree with what we just said in the previous Newsletter, titled “Europe holds key for Chinese stocks in June”. But here is the good news. Chinese stocks are now cheap on valuation and Europe made a significant change in how it’s dealing with the ongoing credit crisis.

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Stocks making up the Shanghai Composite Index (SHA:000001) are trading at 9.7 times earnings right now, half of what they were back in June 2006. U.S. investors can play a recovery of the index by snapping up the Morgan Stanley China A Share Fund (NYSE:CAF), an ETF designed to track the broad Shanghai Composite Index (SHA:000001).

And chances are that Europe will make progress going forward. Policy makers have realized that austerity measures alone will not end the crisis only deepen it. As a result, Spanish and Italian banks now can tap bailout funds directly to shore up their balance sheets without increasing their debt. This is a major shift from an earlier approach where Greece, Portugal and Ireland had to make significant debt reduction promises and spending cuts in exchange for such help. Policy makers realized that debt cuts during recession are counter productive and will result in high unemployment and possible social unrest.

To illustrate what the new financing mechanism will do to Italy and Spain, take a look at the chart below. Cost of debt financing has soared after the 2008 crisis for both of these countries, sending them to the edge of a “death spiral”. The new mechanism will not only replenish depleted capital of troubled banks but will lower demanded premium on Italian and Spanish euro bonds as well. This will help both countries to lower financing costs of already high government debt. The ultimate goal is to restore trust in the markets that Europe’s third and fourth largest economies will remain good debtors, giving the euro zone economy a much needed break.

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Assuming that the Europe instilled rally will hold true, it is worth finding clues from June 29. That day stocks soared globally after the outcome of the EU summit. To find stocks and sectors that are moving, we created two charts. The first one is a breakdown of Chinese industrial sectors for the month of June and the second one is the same break down for just June 29. The divergence between the two is what we are looking for.

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The first observation is that energy and technology stocks made a significant comeback on the last day of the month compared to their flat trading for all of June. Going stock specific, large cap Baidu.com Inc. (NASDAQ:BIDU), Sohu.com Inc. (NASDAQ:SOHU) and SMIC (NYSE:SMI) did best that day from the tech sector. Additionally selected solar names shined, like Yingli Green Energy (NYSE:YGE), ReneSola (NYSE:SOL) and Canadian Solar (NASDAQ:CSIQ). But the rally was not that broad, highlighting that investors have to remain selective with tech names going forward. In contrast to the tech sector, the advance was universal among energy stocks. Yanzhou Coal Mining (NYSE:YZC) was the best performing stock among energy stocks thanks to a 8.2% surge on Friday. Offshore oil producer CNOOC Ltd. (NYSE:CEO) jumped 4.7% while integrated oil companies Sinopec (NYSE:SNP) and Petrochina Co. Ltd. (NYSE:PTR) advanced a more modest 2.4% and 3.0%, respectively. Should oil prices continue to recover, energy stocks look good for July.

Another observation is that financial and basic material stocks continued to outperform the market. Both sectors have a lot of ground to make up and the recovery has just accelerated. China Life Insurance (NYSE:LFC) not only jumped 2.1% last Friday but advanced a solid 12.1% for all of June. Similarly to LFC, Aluminum Corp. of China (NYSE:ACH), Silvercorp Metals (NYSE:SVM) and Fushi Copperweld (NASDAQ:FSIN) have a lot more potential left should EU instilled rally hold true.

Investors have to keep in mind that ultimately fundamentals drive stock prices. And just how much that is true, take a look at the following two charts assessing liquidity of the Chinese solar sector. Once mighty LDK Solar (NYSE:LDK) - red in the charts— reported earnings later in June to the dismay of investors. The company historically had the lowest cash ratio but has been increasingly leveraged. The combination of the two suggests the company is cut off from debt markets and with no cash reserves it will likely to fall victim to the inevitable industry consolidation. Shares of the stocks fell to all time low of $1.91 on June 29.

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Suntech Power (NYSE:STP), another industry icon, is in a tight spot for its low cash reserves and high leverage rate. But Yingli Green Energy (NYSE:YGE), now the largest in terms of revenue, is looking a lot healthier.

With the earnings season around the corner, investors should embrace companies with solid fundamentals. At Chinavestor, we will pay special attention to upcoming numbers from Baidu.com Inc. (NASDAQ:BIDU), Sina Corp. (NASDAQ:SINA) , Sohu.com (NASDAQ:SOHU), Changyou.com (NASDAQ:CYOU), 51jobs Inc. (NASDAQ:JOBS), and New Oriental Education (NYSE:EDU), among others.

Wish you successful investing, Blaze Fabry.



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