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High Risk Yields High Return So Far

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risk_1 June 2013 (Chinavestor) Abundance of money flows continued to drive equity markets world wide for the month of May. With no change in policy for the short term, we expect current trends to continue into the summer of 2013. We highlighted fundamentals driving stock markets globally in our previous Newsletter, e.g. the FED’s $1 trillion/year bond buying policy coupled with Bank of Japan’s (BOJ) decision to double the monetary base within a short period of time. The abundance of cash trickles down to risky assets, including Chinese ADRs and peripheral government bonds, among others. This is clearly seen by the lack of financing woes from countries like Greece, Spain or Portugal.

 

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The index of Chinese ADRs, compiled by Chinavestor, rose 3.6% in May outperforming both the Dow Jones Industrial Average (INDEXDJX:.DJI) and the Hang Seng Index (INDEXHANGSENG:.HSI) for the month. Make no mistake, the US equity market is still a bull market and is going to outperform as long as easy money remains abundant. The Shanghai Composite Index (SHA:000001) surged 5.6% in May and is now in the black for the year.

Were it not for easy credit, stocks would be behaving differently in our view. Here is why.

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Key economic factors, such as unemployment, housing market, consumer confidence and spending, all continue to recover from 2009 lows but are far from historical highs. As a matter of fact, unemployment continues to plague China’s largest trading partner, the European Union. The chart on this page is an excellent visual reminder of the dire state of the EU’s unemployment rate. The US isn’t out of the woods yet either. Unemployment continues to be well above desired levels just as one uncommon index, the Google Unemployment Index on this page testifies. This particular indicator tracks the number of search queries related to unemployment such as food stamps, underpayment, disability etc. While unemployment has been shrinking since 2010, the number of people looking for jobs remains high.

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Improvement in the housing market may seem impressive to many but investors should keep in mind the low comparative base. Consumer spending and confidence is a mixed bag giving no reason for the stellar performance of stocks globally. Again, we continue to believe that the Dow’s record highs are attributed to the abundance of stimulus money flowing into equity markets.

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Looking at other important measures in Europe, a key market for Chinese exports, like retail sales and consumer loans, the picture is far from rosy. Again, we find no fundamental reason for the stellar performance of equities other than the FED’s and the BOJ’s accommodating policies.

If that is the case, what do we expect from Chinese ADRs going forward?

We think stocks will behave the same way in June as they did in May of 2013. Risky stocks will continue to reward investors while safer assets will continue to be under pressure. This was the case4 in May when technology and risky capital goods stocks outperformed while utilities, transportation and energy stocks suffered.

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U.S. based China stock investors have to keep in mind that large cap, less risky, quality stocks like Petrochina (NYSE:PTR), China Mobile (NYSE:CHL) or China Southern Airlines (NYSE:ZNH) all underperformed in May while some quality tech stocks and capital goods rallied.

We welcome the strong performance of quality tech stocks like Baidu.com (NASDAQ:BIDU), NetEase (NASADAQ:NTES), Sohu.com Inc. (NASDAQ:SOHU) and Qihoo 360 Tech. (NYSE:QIHU). But we continue to stay away from the solar sector whose performance is reminiscent to a roller coaster not to regular stocks.

Looking at capital goods sector, the bad news is that even the largest component of the sector is a small cap company China Yuchai International (NYSE:CYD). The average trading volume is a mere 40,000 shares/ day for the last three months, really not investment grade. And again, this is the largest component of the sector, the rest is even less desirable. This suggests we have to take the 104.5% rally from Cleantech Solutions (NASDAQ:CLNT) in May with a big dose of grain of salt.

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But if investors are willing to take on high risk, our suggestion is the consumer non-cyclical sector for the summer. Chinavestor’s money flow charts, tracking money in- and outflows from sectors, reveals strong money flows in the consumer durable sector. The indicator reveals a potential break out situation when money flows exceed relative performance of the index. This is the case with the consumer non-cyclical sector right now. The sector is similar to the capital goods sector in terms of stock composition. Both sectors have only small cap, high risk components. This is why none of them will make it even to the Growth portfolio, published alongside this Newsletter.

But if someone is willing to take such risk, stocks like Zhongpin Int. (NASDAQ:HOGS), Synutra International (NASDAQ:SYUT) and Agria Corp. (NYSE:GRO) are potential targets.

The same money flow analysis reveals that disappointing performance from Huaneng Power International (NYSE:HNP) in May was not just a fluke but the stock suffered heavy money outflows. This in turn suggests a quick recovery is highly unlikely.

Wish you successful investing,

Blaze Fabry



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