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Hold your horses in December

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bull_bear3 December 2012 (Chinavestor) November continued where October has left off: an ever yawning gap between the Shanghai Composite index (SHA:000001) and the Hang Seng Index (INDEXHANGSENG:.HSI). To be precise, the Shanghai Composite Index (SHA:000001) fell 4.3% in November and is down 8.7% year-to-date (YTD), a sharp contrast to the Hang Seng’s 16.7% gain YTD. Good news for China stock investors in the U.S: despite a free fall of Chinese stocks in Shanghai, the composite of U.S. listed Chinese stocks is still up 7.3% YTD. The China ADR index, compiled by Chinavestor, shows a mere 0.7% decline for November. A 7.3% advance YTD from the China ADR index is comparable to the performance of the Dow Jones Industrial Average (INDEXDJX:.DJI). The Dow is up 5.1%, slightly below the China ADR Index.



Investors have to go back in time to fully understand the unusually sound performance of the Hang Seng Index (INDEXHANGSENG:.HSI) in 2012. This particular Chinese index has historically correlated very closely to the Dow due to a combination of factors. And while the Dow fully recovered by the end of 2011 from an earlier slump that year, the Hang Seng Index declined over 20% in 2011. This in turn meant that the Hang Seng had a lot of ground to make up in 2012, a recovery that has been taking place in the second part of this year.

Investors also have to understand that while the Hang Seng Index correlates very closely to the Dow, there is a lot less significant correlation, if any, between the Hang Seng and the Shanghai Composite. Reason being that investors in Hong Kong are driven by growth rates denominated in the Hong Kong dollar, a currency that is pegged to the U.S. dollar, not to mention that interest rates in Hong Kong mimic that of the U.S. as well. In contrast, investors in Shanghai focus on Chinese domestic news, growth trends and are a lot less moved by trends from the western world.

U.S. investors with a China hat on have the benefit of both worlds when the home base is doing well. This is clearly demonstrated this year when every major American index is up YTD and so are Chinese ADRs. Yet these investors have the benefit of digesting every news coming out of China, preparing themselves for a possible correction ahead of time.

US Housing Stats and Reversed Rates 2003-2012


Source: Thaler's Corner

Looking at the macro level, I share a cautious optimism not for December but for early next year. Here is why. I expect the negotiations around the “fiscal cliff” to drag on up until the last minute or beyond. This in turn will hurt investor sentiment globally. But we might have some sort of an “agreement” in January, a catalyst for the beginning of the year. Another factor holding me back in December is the situation in Europe. Despite a successful round of financing for Greece, the fundamental problems, e.g. unsustainable debt levels and chronic unemployment in a recession, continue to pose a risk for the Euro zone. This again is hurting consumer spending in Europe and drag on the global economic recovery. When it comes to China, the macro situation is encouraging. They have just completed a power transition and the new leadership is expected to continue to focus on sustainable economic growth. The good news is that inflation is not a problem in China at the moment. Core CPI, or consumer price index ex food, remains stable thus giving room for policy makers to spur growth. Latest manufacturing data suggested industrial output has accelerated in China after a severe slowdown earlier this year. All these are pointing to a modest pick up in economic activity in the second largest economy in the world.


Source: Guinness Atkinson

Another reason I am bullish on China is valuation. Components of the Shanghai Composite Index are trading at 8.6 times earnings, back at 2008 lows. But again, timing is key. I think as soon as the U.S. tackles the “fiscal cliff” problem, investors may have a good opportunity to buy at the cheap.


Investors want to know what exactly to buy then? We have to wait and see what December brings first, but right now industrial, materials and energy stocks look good to me. Chinese technology stocks fell out of favor in November as the nearby chart testifies. In fact, the tech sector fell 5.7% in November, the most among major sectors. Unfortunately for investors, the decline was driven by fundamentals—e.g. disappointing earnings and lack of growth. Inc. (NASDAQ:BIDU) was off 8.4% in November but that’s nothing in comparison to a 19.2% decline by Inc. (NASDAQ:NTES) or Sina Corp.’s (NASDAQ:SINA) 14.2% fall. These internet heavy weights are suffering due to lack of earnings growth, a signal that China’s internet boom has come to a halt. When industry leaders suffer, so does the rest of the sector, a common wisdom seasoned investors know. This in turn implies recovery of the internet sector will have to wait.


Chinese solar stocks continued to trade in a wide range. LDK Solar (NYSE:LDK) surged as much as 35.1% in November but Trina Solar (NYSE:TSL) tumbled 29.5% on the same time. But again, investors have to look at fundamentals to make sense out of these wide swings. LDK Solar (NYSE:LDK), the best performing Chinese solar maker in November, remains liquidity strapped despite news that the Chinese government will hand out a bail out. In fact, LDK Solar (NYSE:LDK) is the highest leveraged solar maker requiring ongoing debt financing just to keep its operations running. From that respect, Novembers’ surge is more like a dead cat bounce than a well founded turnaround.


Many investors have disserted Chinese stocks lately, a visible sign being a lack of volume at previously liquid stocks. Some compared trading of Chinese stocks to a grand casino, and for a good reason. A series of accounting scandals have rocked investor confidence, including ours. Now we reserve ourselves to larger cap, transparent stocks that is reflected in our stock selection process for the Conservative and Growth portfolio.


One stock we have liked for most of the year and has been a highlight in our portfolios is Huaneng Power International (NYSE:HNP). China’s largest independent power generator has been outperforming every major stock this year. Our money flow analysis reveals that the current rally is well founded and is accompanied by equally large money inflows. This in turn suggests the rally is not exhausted yet. See nearby chart for yourself.

Wish you successful investing,

Blaze Fabry

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