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Preserve Capital in Down Markets

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bull_bear3 February of 2013 was a surprise month to us. While Chinese indexes fell for the month, the Dow continued to advance close to record levels. For the record: the Hang Seng Index (INDEXHANGASENG:.HSI) fell 3.6%, the most among major Chinese equity benchmarks. The index is still up 21.2% for the last 14 months, way ahead of the Shanghai Composite Index (SHA:000001) and the China ADR Index. The latter one, measuring the performance of Chinese ADRs listed in the U.S., fell 2.2% in February in line with the Shanghai Composite Index. Chinese investors locked in profits in February breaking a three month winning streak. Reasons for the sell-off were manifold. While overall inflation remained relatively modest for the month, home price increases were alarming. Measured in the 22 largest cities in China, home prices rose at the fastest clip in over two years, prompting the politburo to clamp down on an overheated property market. Financial, construction material, and property stocks suffered but downside was limited thanks to record quarterly profits from China Vanke (SHE:200002), the largest property developer of the country.

The global economy remained vulnerable as increased volatility after the indecisive Italian elections testified.


But none of the bad news seemed to matter for investors in the United States. In fact the Dow Jones Industrial Average continued to advance for most of February and was off by a mere 22 points from its highest ever recorded. The S&P 500 showed strong gains as well. Apple Inc. (NASDAQ:AAPL), an index heavy weight, was a drag on the NASDAQ but most of its components advanced. An outsider would assume the world and in particular the U.S. economy was in high gear with a positive outlook.

But it is not the case. The U.S. economy grew a mere 0.1% in the last quarter, a revision that made all the difference from a contraction to an expansion. Yet there is nothing to celebrate about this paper gain for unemployment remains high and Washington remains dysfunctional. Major headlines call our government a global embarrassment as the sequester hits. Another reason to question the Dow surge is upcoming inflation, an inevitable development now that the FED is printing money at a fast clip to stimulate the economy.

And if this wasn’t enough to worry about, let’s take a look at Europe, a continent that has been weighing on U.S. equity markets since 2008. Latest Italian elections delivered instability and uncertainty to the third largest economy of the Euro zone. Without analyzing how Italy can be governed after the elections, an almost impossible task after looking at current breakdown of Senate seats in the country shown on this page, one thing is certain. Any meaningful structural reforms are put on hold after voters had enough of Brussels dictated cash-for-austerity.


The high unemployment rate in Greece and Spain, especially among 25 and younger, not only turns violent from time to time as street protests continue, but it also continues to plague economic recovery. England was stripped of its valued AAA rating earlier in the month signaling that problems are not limited to the Euro zone alone. Again, economic troubles in the old continent should caution U.S. investors at a time when the Dow is above 14,000. We understand that consumer confidence is high, as is evidenced by the increase of consumer debt for the first time since 2008, and that corporate earnings were sound for the most part, but investors should never lose sight of the big picture described before. The global economy is vulnerable and the U.S. economic recovery remains fragile and depends on FED stimulus and government spending.

For this reason we gave the title “Preserve Capital in Down Markets” to this issue of our Newsletter. Again, we think it is prudent to lock in profits in early March because down markets look a real possibility in our view.

Economic growth in China was within the error of margin at 7.8% for the quarter and is expected to pick up some speed for the rest of 2013. China is looking a lot better from a financial point of view than Europe thanks to a strong domestic consumption and a large foreign currency reserve.

Manufacturing expanded in China for January and February while inflation picked up but remained manageable. See Consumer Price Index chart for China on the page below.


But macro economic data doesn’t necessarily translate to gains in an investors portfolio, as was the case for the month of February. Major Chinese indexes fell for the month just as we described it on the first page of the Newsletter. Even more painful, Chinese stocks listed in the U.S. underperformed U.S. indexes by a wide margin. Just as painful, the decline was universal except for Capital Goods stocks as the chart on this page testifies.


The devil is always in the details as we know and this is true for the capital goods sector this time as well. Xinyuan Real Estate (NYSE:XIN), a small cap, under the radar real estate developer from China, jumped 45.6% in February, skewing the whole sector to the upside. But other than this particular stock, there was not much to celebrate even among components of the capital goods sector. And now the bad news: financial, basic material, technology and consumer cyclical stocks fell between 8% to 11% for the month, wiping out precious gains from investor portfolios.

China Life Insurance (NYSE:LFC), the largest Chinese life insurer and a former blue chip, fell 11.7%, sinking the rest of the sector with it. The two largest components of the basic materials, Aluminum Corp. of China (NYSE:ACH) and Silvercorp Metals (NYSE:SVM), fell 9.7% and 14.5%, respectively.

The decline was universal among components of the consumer cyclical sector. China ZX Auto (NYSE:ZX), Deer Consumer Products (NASDAQ:DEER), and China Automotive Systems (NASDAQ:CAAS) fell 10.9%, 26.8% and 14.2%, respectively.

The technology sector is the most diversified and has the largest number of components among any other Chinese sectors. As a result, the decline was not universal but some trends and facts are worth paying close attention to.

Chinese solar stocks continued their casino behavior. Suntech Power (NYSE:STP), Trina Solar (NYSE:TSL), and Yingli Green Energy (NYSE:YGE), some of the largest PV makers of the world, fell 27.5%, 21.3% and 11.8% in February, respectively. Investing in these stocks is extremely risky and requires a strong stomach.


Internet darling Inc. (NASDAQ:BIDU), the sector heavy weight and bellwether for the internet industry, continues to suffer. Investors didn’t like the latest financial report because the company was not persuasive in the mobile advertisement market, a shift that has been taking place in the U.S. and is expected to catch up with China sooner rather than later.

Baidu’s lack of traction in the mobile market is particularly upsetting because trends like this, a shift from online ad to mobile platforms, is well documented and visible in developed markets. Hewlett-Packard (NYSE:HPQ) and Dell Inc. (NASDAQ:DELL) are here to testify how painful the switch from PCs to mobile devices is for manufacturers and service providers. Yet the task, e.g. reaping benefits from the switch, is not an impossible task to accomplish, as Google Inc. (NASDAQ:GOOG) is here to testify. The world’s largest search engine company broke through the $800 share price for the first time after mobile revenue growth reassured investors.

Another reason for highlighting Google’s results vs. Baidu’s is that it proved once again that there is no place for a straight comparison between an American company and a Chinese one, even if their operations are seemingly identical.

Qihoo 360 Technology (NASDAQ:QIHU) has been grabbing market share from BIDU, a stock we prudently placed in the Growth portfolio several month ago.

Baidu’s weakness sent other internet stocks falling. Sina Corp. (NASDAQ:SINA) fell 4.8% while Inc. (NASDAQ:SOHU) declined 6.8% for the month. Only NetEase Inc. (NASDAQ:NTES) bucked the trend among major internet plays by advancing 10.8% for the month. This was a welcome relief for our Growth portfolio.

Finally, we have to warn investors about risks associated with Chinese stocks. The inability of the SEC to persuade the appropriate Chinese regulatory body to cooperate in the auditing of Chinese companies before their U.S. listing is very troublesome. We wrote about the questionable accounting practices of Chinese companies in several previous Newsletters and we continue to raise the issue. We recommend investing in liquid, larger cap Chinese ADRs only and only in those that won listing in the U.S via IPO. Any Chinese ADR that got listed via reverse merger raises the red flag and should be scrutinized further.

Subscribers can contact me for a list of safer IPO stocks. Wish you successful investing, Blaze Fabry.

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