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June 2010 Newsletter: China stocks sink to 2010 lows in May.

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decline_6 If asked what was the most memorable event in May, many of us would think of the 1,000 swing of the DJIA (INDEXDJX:.DJI) on May 6 at 2:30. While it was an unfortunate event, most of the damage came in the second part of the month. Major U.S. indices were off by eight percent in May while Chinese ADR fell even harder. The cap weighted China ADR Index, compiled by Chinavestor, tumbled 9.3% for the month and is off 12.0% YTD.

The Shanghai Composite Index (SHA:000001) fell another –7.5% in May after a –7.7% dive a month ago, entering into a bear market, officially. Any dive of over 20% is considered bear. The Hang Seng Index (INDEXHANGSENG:.HSI) fell –6.4% for May, outperforming the rest of the Chinese markets.

Stocks mentioned in this report: Spreadtrum Comm. (NASDAQ:SPRD), China TechFaith Wireless (NASDAQ:CNTF), Home Inns & Hotel Mgmt (NASDAQ:HMIN), Ctrip.com (NASDAQ:CTRP), Baidu.com (NASDAQ:BIDU), Xinhua Sports & Ent. (NASDAQ:XSEL), China Nepsar (NYSE:NPD), WSP Holdings (NYSE:WH), Huaneng Power (NYSE:HNP)

What’s new is that international markets and events took center stage in May, determining the direction of U.S. equities.

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Taking a closer look at the chart displaying the performance of Chinese indices and the DJIA (INDEXDJX:.DJI) year-to-date (YTD), it is apparent that the fall of Chinese indices preceded that of the DJIA. I remember a large number of market days when the Shanghai Composite Index (SHA:000001) went to the totally opposite direction of the DJIA INDEXDJX:.DJI) for couple of days in row. This means that Chinese investors were less occupied by U.S. economic news but focused on Chinese events instead. This is a break-away from the past when Chinese indices were pretty much following U.S. market sentiment. But with the growing might of the Chinese economy and capital markets, investors in China have started to take clues from Chinese news and not overseas in large numbers for the first time.

Another big driver for May was the trouble with the common currency of the European Union, the Euro.

The correlation between the Euro and U.S. capital markets is more profound than it would seem for the first sight. Fact of the matter is that when the dollar gets stronger against the Euro, oil and commodity prices plunge in dollars. Lower oil prices punish index heavy energy stocks, lower commodity prices hurt basic materials. We have seen an awful lot of down days in May that started out by plunging energy prices.

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Investors have little tolerance for additional risk, as is evidenced by the increased volatility for the month. Just think of the infamous May 6, 2010 when the DJIA (INDEXDJX:.DJI) fell over 900 points at 2:30 in ten minutes before it recouped most of the losses.

Or think of tiny Greece whose possible default on debt plunged the Euro to four year lows before Spain and Portugal got a downgrade.

After the 2009 bailouts in the U.S. and Europe, the public has little appetite for more. This makes investors nervous for not having another silver bullet available in case things go bad.

The bad news is that the market turnaround will have to wait at least a month or two for a number of reasons. For one, Europe’s troubles will not go away quickly. The lack of swift, decisive action on behalf of the European Central Bank at the beginning of the Greek crisis suggests there is uncertainty that the rich northern nations have the political will to foot the bill. A shortage of political will is tangible in Germany, the largest European economy.

It was fun to see Treasury Secretary Tim Geithner chiding the largest E.U. nations on monetary policy at the end of May, a year after the world, including Europe, blamed the U.S. and its monetary policy for the largest recession in a generation.

Another reason that equity markets will remain under pressure in June is that China’s troubles won’t go away quickly either.

While inflation and economic growth remain very encouraging, taming the property market turned out to be a hard nut to crack for Chinese policy makers. A number of harsh and Draconian measures have failed to dry up excess liquidity pouring into the property market. As the sales price indices of large and medium size cities chart testifies, the prices have continued to rise in China’s largest cities since March 2009.

What’s behind such a strong market force?

It started out by the economic stimulus package of 2008 when Chinese policy markets pumped RMB4 trillion ($586 billion) liquidity into the Chinese economy. A large part of the money went into a wide range of infrastructure development, stemming from roads and airports to commercial and residential construction. What started out as a blessing turned to be a curse, at least for the short term.

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With so much money around with a limited number of alternative investments, a large number of investors entered the property market. Banks pay little interest and with inflation under 3 percent, chances are low that interest rates will rise any time soon. The Chinese had a tough luck with the equity markets so far. The Shanghai Composite Index (SHA:000001) soared from 1,100 in October 2005 to 6,000 by October 2007 but fell to 1,700 the following year, reminding ordinary investors that stocks do not always go up. This bitter realization left a deep mark in the minds of Chinese retail investors, preventing them to return to the equity markets in 2009 and 2010.

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The good news is that while property prices continue to climb the number of transactions have started to decline, suggesting some of the measures to cool-off the market have started to gain traction. This is illustrated in the chart tracking selling price and trading volume in SongJiang District of Shanghai.

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Despite a difficult month for equity investors globally, quality earnings from a selected number of blue chip companies made a difference. We took note of the outstanding first quarter number from Home Inns & Hotels Management (NASDAQ:HMIN), Ctrip.com International (NASDAQ:CTRP) and Baidu.com (NASDAQ:BIDU). Liitle known Spreadtrum Comunications (NASDAQ:SPRD) caught us by surprise—though the overbought monitor kept us informed about the rally that has accelerated after May 17 as the company surprised to the upside. China TechFaith Wireless (NASDAQ:CNTF) jumped over 20% on May 19 as earnings rolled in. And just as earnings propelled quality stocks higher, disappointing quarterly reports severely punished smaller cap China stocks. Xinhua Sports & Entertainment (NASDAQ:XSEL) reported revenues tumbling 44.6% YoY and rolling up $585 million in the last two years. With $13 million cash at hand, it is hard to see how the company will make it through the next 12 months. China Nepstar Chain Drugstore (NYSE:NPD), WSP Holdings Ltd.(NYSE:WH) all tumbled on disastrous 2010 first quarter financials.

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Solar stocks and Huaneng Power (NYSE:HNP) look undervalued at this point, based on better-than-expected earnings and falling stock prices—something value investors should pay attention to. Wish you successful investing,

Blaze Fabry

 

 



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