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March 2009 Newsletter: DJIA goes bust. What does it mean for China stocks?

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Hopes in January that the worst may be over soon were hammered in February after the Dow Jones Industrial Average dropped to 50% of its peak, a peak it hit just 16 months ago. The decline in stocks was broad and went beyond the financial sector. By the end of the month we learned that the U.S. economy experienced its worst fall since 1982 as output shrank by an annualized weight of 6.2% in the last quarter in 2008.

Accordingly, our standard “Major Indices” chart on the first page is bleak as three of the four important benchmarks continued to deteriorate throughout the month of February. But this time we realize some unusual pattern. While the DJIA in yellow recorded the largest loss year-to-date (YTD) 19.5% including an 11.7% drop for February, the Shanghai Composite, in brown, gained 5.1% despite heavy sell-offs at the end. The performance of the Hang Seng Index and the China ADR Index is related closely to the performance of the Dow and are down 14.8% and 9.0%, respectively.

As we pointed it out in the previous Newsletter, Shanghai’s resurgence is driven by fundamentals and as such is broad and less likely to collapse overnight. What’s unusual besides the totally different direction of the Shanghai Composite and the DJIA is that American listed Chinese stocks, or ADRs, got momentum from Shanghai more than ever before. The China ADR Index (CAI) outperformed the DJIA by a wide 11% margin in February.

This relatively stellar performance of the CAI is attributed to the modest fall of index heavy weight Petrochina and China Mobile and a 5.8% gain of large cap China Life Insurance (LFC) and a 15.2% gain of (BIDU).

What’s been propelling the Shanghai Composite lately is hope that China’s stimulus package will trickle down to the company level and keep the world’s third largest economy growing at the targeted 8%.

The good news is that the global economic crisis has had little effect on China’s banking system. Banks have been stepping up lending since November 2008 following the announcement of China’s 4 trillion Yuan stimulus package. Bank loans hit 1.6 trillion Yuan in January, a monthly record, as investments into railways, power projects, roads and related infrastructure were soaring. Some argue that China stocks are the best bet during the global slowdown and stocks in Shanghai should continue to outperform until the Chinese economy recovers and sucks liquidity out of the stock exchange. JPMorgan Chase & Co. went even further saying that “Emerging markets including China may be the first to recover from the global recession”.

As China’s stimulus is being unveiled more projects fill in the pipeline. One is Huaneng Power’s (HNP) 4.2 billion Yuan ($614 mil) power plant in Hunan province while another is CNOOC Ltd.’s (CEO) liquefied natural gas storage facility. In December China’s third largest power generator won approval to build a 1,200-megawatt power plant.

As far as the petrochemical industry is concerned, the country has approved $35 billion in government spending since November 2008 for the industry. According to government officials the stimulus plan will seek to increase stockpiles of oil products, expand loans, build up diesel-supply networks in rural areas and accelerate construction of key refineries and ethylene plants. New projects include the construction of the eastern branch of the second west-east gas pipeline valued at 93 billion yuan ($14 bil).

Will these measures be enough for China to weather the storm relatively well is a question.

Pessimists point out that increased bank lending may contribute to a massive bad loan run-up and it hasn’t fueled economic growth yet As the chart on this page testifies China’s GDP has been declining since the first quarter of 2008 resulting in a 9.0% average growth for the year. This in turn marks the end of double digit growth since 2002.

The bad news is that Chinese port operators reported lower volumes of containers for February, underlying that an early rebound is unlikely. And while China is the only major economy in the world that is still growing, the country is dependent on the world economy for a sustainable growth. As exports shrink and consumers buy less foreign goods 15% of the estimated 200 million migrant workers have lost their jobs and returned to rural areas. Most analysts agree that China needs an 8% growth to create enough jobs to fill new entrants into the work market and the government seems to be serious to achieve such growth. According to Nomura’s chief economist, Mingchun Sun, the Chinese government is considering to double the stimulus package to 7-8 billion Yuan to hit its growth target. The fact of the matter is that China has massive public investment needs but just as importantly it has means to pay for them.

Looking at the Shanghai Composite as an indicator for the future, the picture is getting opaque. The index gave up 16.5% in the last two weeks of February suggesting that an early recovery is less likely.

The short term problem for the index is that commodity producers are under increasing pressure on concerns that the global recession will dampen demand for raw materials and batter profits. And despite efforts by the Chinese government to support metal prices by buying up large amounts of aluminum and zinc in particular, prices continued to deteriorate.


So far government efforts in China resulted in an improvement of the Shanghai Composite, but it is too early to tell if the trend will continue. Latest developments suggest that the stock market adjusted following the rally and is looking for directions from here. But just how much uncertainty is out there let me quote from Warren Buffet’s letter to Berkshire Hathaway shareholders. “We're certain, for example, that the economy will be in shambles throughout 2009 -- and, for that matter, probably well beyond -- but that conclusion does not tell us whether the stock market will rise or fall." And likewise, we at Chinavestor don’t know where Chinese stocks are heading for the rest of the year—nor in the U.S. We continue to be bullish for the long-term based on fundamentals but it’s difficult to suggest a buy when all major indices head south.

But to give you some guidance how to follow certain markets, the following ETFs are worth considering. The iShares FTSE/Xinhua China 25 Index (FXI) correlates closely with the performance of the Hang Seng Index, or even closer to the Hang Seng H-share index. Hong Kong’s open markets make it an easy target for the global slowdown but at the same time when recovery occurs, expect the FXI to explode.

If you think the Shanghai Composite will continue to outperform the rest of the world, your choice is the Morgan Stanley China (CAF) ETF. This has been following the performance of the Shanghai Composite very closely. If you had CAF positions since the beginning of 2009, you would be up over 20% for the year or even better, would beat the DJIA by a wide 40.3% margin!

Going stock specific let’s review what’s been working for 2009 so far and what didn’t. We called on shorting the whole solar sector in our January Newsletter and it proved to be a smart call. Disappointing 2008 Q4 earnings with a weak outlook for 2009 from industry leader Suntech Power Holdings Co. LTD (STP) sent China solar stocks down the tubes. Suntech is down 47.95% YTD with no signs of a sustainable recovery.

Another good advice we had was to buy (SOHU) in the January issue as the stock is up 4.3% YTD but even better, it is up 24.5% for the month of February.

Another NASDAQ listed China stocks we recommended to buy was NetEase (NTES). And while the stock was weak in January it gained momentum in February resulting a –7.3% performance for the year so far. Considering that the DJIA lost 19.5% YTD, NetEase was a good bet.

In the same January Newsletter we made a case for Chinese airliners and we repeated the appeal a month later. Chinese South Air (ZNH) and China Eastern Air (CEA) are down –2.4% and –4.1% for February and down –9.1% and –13.4% YTD, outperforming the DJIA for both periods.

Another good call we made was Shanda Interactive in February as the stock rallied 12.8%.

We made a case for Sinopec (SNP) and though the stock lost 2.9% in February it’s way ahead compared to the DJIA. We continue to like the stock on fundamentals.

We continue to like Huaneng Power (HNP) despite a relatively weak performance for February. The stock lost 8.8% but again, it’s ahead of the DJIA. The case for Huaneng is the following. Chinese coal miners got hammered lately as coal inventories rose at power companies, resulting in falling pricing power of coal miners ahead of price negotiations for the year. Chinese power companies were bleeding in 2008 and it seems as if the government is more inclined to help power companies this time. Additionally power companies are prime beneficiaries of the stimulus package and Huaneng, China’s largest independent power company, is well positioned to get a piece of the action.

We made some bad calls as well. The9 Ltd. (NCTY) lost 22.8% in February when we called it a buy. We also failed to give a buy signal for Baidu in February following a “don’t touch” warning in January. The stock rallied 15.2% in February following better then expected 2008 Q4. As far as the outlook for Baidu, we’re bullish again on the stock based on fundamentals. The stock may take a breath in the upcoming weeks following the strong rally but for the short to medium term we think Baidu is a good buy.

We continue to like (SOHU) and Shanda Interactive (SNDA) from the NASDAQ.

We’re cautious about (CTRP), China’s premier online travel agent, following 2009 guidance. While valuation is not a concern weak outlook for the industry certainly is.

Another stock we continue to like is Aluminum Corp. of China (ACH). Latest government efforts to consolidate the aluminum industry favors ACH, not to mention the fall out of the stimulus package.

Concerning the outlook for March, let’s take a look at the Hang Seng AH Premium Index . This index measures the price difference of the same stock between its Shanghai and Hong Kong listing. Despite a weak last two weeks in Shanghai the premium index is holding up. This in turn may suggest a rally for the Morgan Stanley China (CAF) ETF, at least for the short term.

Hang Seng China AH Premium Index


Indices and ETFs 2009 YTD


China GDP Growth 2008


Major Indices in 2009


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