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Embrace Volatility for Rest of 2013

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rollercoaster July 2013 (Chinavestor) We argued that high risk had yielded high return in 2013 so far in our last Newsletter, but that is about to change in our view. We are uncertain about the speed of change but the underlying force, e.g. the abundance of easy money, is about to change.

Before examining what we expect going forward, let’s just take a look at the record for June. The Dow Jones Industrial Average (INDEXDJX:.DJI) gave back -1.4% in the month but is still 13.8% up year-to-date (YTD). That is the best first six month performance for the index since 1999!

But Chinese equities and indexes failed to take advantage of such a rally. The Shanghai Composite Index (SHA:000001), measuring the performance of domestic Chinese equities, tumbled -14.0% in June and is down -12.8% YTD.

The Hang Seng Index (INDEXHANGSENG:.HSI), the index of the most liquid blue chips in Hong Kong, fell –7.1% in June and is off –8.2% YTD.


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The index US investors with a China spin should be most concerned about, the China ADR Index measuring the performance of Chinese ADRs listed in major US exchanges, fell -2.7% in June and is off –10.0% YTD.

Now the Hang Seng Index and the Shanghai Composite Index are in-line with the China ADR Index for the first time in 2013. All of them are down deep in the red, a sharp contrast to the superb performance of the Dow.

Going forward, one thing is certain: uncertainty is growing. FED Chairman Ben Bernanke indicated that he sees 2014 end for QE3, a major change for the underlying support for the Dow.

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To illustrate how much quantitative easing influences stock markets, let’s take a look at the first above. There is a clear correlation between Japan’s commitment to double the monetary base in four years and the performance of the Nikkei 225. The Nikkei is on fire ever since Japan’s plans to enter into a competitive devaluation of its currency started this year. The US dollar strengthened 24.17% against the Yen so far this year while the Nikkei soared twice as much, 51.8% at the same time. The same is true for major US indexes, e.g. the FED’s accommodating policy is primarily responsible for the Dow’s record breaking trend since 2009. See chart below for details.

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Another highly visible gauge of the effect of easy money is the gold price chart below. See SPRD Gold Trust (ETF) YTD. Gold futures for August 2013 fell to $1223.70 an ounce representing a loss of 23% for the quarter, the steepest quarterly decline since the start of Comex gold trading in 1975! For one, hedging against inflation is diminishing as the FED curtails the printing machine. But just as importantly, investors shunned gold when little risk in equity markets has earned high return for the past six months.

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The big question is what is going to happen when the $85 billion/month bond buying will be over.

For one thing, interest rates will go up. The same week when Mr. Bernanke spelled out the most likely scenario for the tapering off for bond buying, 30-year mortgage rates experiences the steepest one week rise since 1987 and jumped to two-year highs. Investors invested in complex vehicles such as short 20+ year Treasury ETFs (ticker symbol “TBT”) reaped benefits instantly.

Besides a major shift in interest rates, we are of a view that the Dow and all major US indexes will experience a correction. Short index ETFs may come to play but again, such volatile and complex ETFs are not necessarily suitable for average investors.

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Volatility is not limited to US equities alone. The Shanghai Composite Index fell over 10% within a short period of time at the end of the month as fears of a major financial meltdown spooked markets. The second chart on this page shows how the index fell from 2,150 to 1,850 before recovering some of the losses. The financial system in China grapples with tight credit markets where prime rate jumped to over 10% for a short period of time. It is still uncertain what long term complications might arise but again, volatility globally is on the rise.

So what’s the best course to take for US investors with a China spin? Let’s take a look at how Chinese ADRs did for the last month.

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Other than consumer non-cyclical stocks, all major industry groups fell for the month. Consumer durables, healthcare and technology stocks have been among the best for all of 2013. What gives investors a headache with consumer durables is that the group is represented by small cap stocks with low visibility and little transparency. These are those “don’t touch” stocks we have been warnings investors about for a long time. And just as a reminder how much risk still persists with such stocks, take a look at once prominent advertising company, Focus Media Holding Limited (NASDAQ:FMCN). The stock stopped trading on the NASDAQ late May leaving investors settled with steep losses.

Basic materials, transportation, financial, and energy stocks are those of interest going forward. All these sectors are represented by large cap, relatively liquid quality Chinese stocks that investors may want to give a second look.

Aluminum Corp. of China (NYSE:ACH), China’s largest aluminum maker, fell 20% in June while Alcoa Inc. (NYSE:AA) slid 8.85%. We understand that investors are concerned about slower Chinese economic growth but argue that a 20% decline was an overkill and ACH may bounce back in the next three to six months.

Airliners led the decline for transportation stocks and we see more upside potential then downside risk for the sector going forward. China Southern Airlines (NYSE:ZNH) and China Eastern Airlines (NYSE:CEA) are ripe for a comeback in our view.

Yanzhou Coal (NYSE:YZC) among energy stocks is of interest but we’re less enthusiastic about financials like China Life Insurance (NYSE:LFC) or China Finance Online (NASDAQ:JRJC).

Wish you successful investing,

Blaze Fabry.



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