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How long can an artificial rally last?

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denial_1 January 2014 (Chinavestor) 2013 may be a banner year for stocks but investors have to keep in mind that there is a something brewing under the surface. This Newsletter is going to shed some light into the dangers of the current asset price increase and give advice about possible timing.

For the record, the Dow Jones Industrial Average (INDEXDJX:.DJI) advanced 26.5% in 2013, the best calendar year performance since 1997. The Nikkei 225, Japan’s most widely used benchmark, surged as much as 50.82% in the same year. But the advance was limited to countries that entered the so called “competitive devaluation” race where diluting the monetary base reached record highs.

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The Shanghai Composite Index (SHA:000001) lost 6.7% at the same time, contrary to the superb performance of the Dow or the Nikkei. The Hang Seng Index (INDEXHANGSENG:.HSI) advanced a mere 2.9% outperforming the US listed China stock benchmark, the China ADR Index which rose 1.7% in 2013.

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The Bank of Japan announced earlier in 2013 that it would double the monetary base within four years and continue on an aggressive bond buying program in the subsequent years. The best way to put this aggressive action into perspective is to see the Nikkei 225 performance for the last five years. This is the second chart on this page. It is obvious that the 50% plus advance in 2013 is clearly the effect of an artificial policy that keeps interest rates low and dilutes the value of the local currency. See the third chart displaying the USD versus the Yen, the Yuan and the Euro. The US dollar and even more the Chinese Yuan clearly strengthened against the Japanese currency in 2013. The effect of a massive dilution of the value of local currencies is yet to come in the form of domestic inflation, something we haven’t seen yet. But those traveling abroad know the devastating effect of a lower dollar value visiting any country from Europe to Australia.

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While the FED’s policy of buying $85 billion/month or over $1,02 trillion/year T-bond is not as aggressive as action taken by the BoJ, the effect is similar in nature. Sharply rising equity values and falling currency values. See the robust trend of the Dow Jones Industrial Average in 2013, first chart on this page. By the way, China’s insistence on trying to peg the Yaun to the dollar is welcome news for those buying goods made in China, keeping domestic inflation at bay.

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But investors need to understand the reason behind such an asset price bubble to prepare some market timing.

First and foremost, the FED holds the key. As long as it keeps interest rates low, investors will continue to flock to equity markets to earn return on savings. This suggests the bulls will continue to occupy the driver seat in the fist half of 2014. But things can change when the economy picks up, unemployment improves and the housing market heals. There will be little excuse left for the FED and the government to continue to bury America in debt. Should the FED significantly taper off its current program and let interest rates rise, inflated asset prices will experience a painful correction. Based on current communications, this can come anytime but most likely not until the second half of 2014.

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What does it mean for Chinese stocks? It is hard to say. Chinese stocks missed out on the rally in 2013 and very well may continue to remain at bay for the next 6 months. Based on our calculation, only 40% of all U.S. listed Chinese stocks trade above both of their 50 DMA and 200 DMA at present. All 30 Dow components measure a lot better for the same momentum indicators. See performance of the Dow components on the previous page.

When it comes to Chinese stocks only the technology sector offered viable alternative as the chart on this page testifies.

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It is important to point out that size matters in the chart, e.g. the size of the bubble representing combined the market cap of all sector components. The red bubble representing the tech sector is not only remarkable in size but has had the best performance of all Chinese sectors in 2013. Baidu.com (NASDAQ:BIDU), the industry leader, rose over 75% but so did NetEase (NASDAQ:NTES) and Qihoo 360 Tech. (NASDAQ:QIHU). Sina Corp. (NASDAQ:SINA) and Sohu.com Inc. (NASDAQ:SOHU) followed suit. But energy stocks disappointed the most. Petrochina (NYSE:PTR) and Sinopec (NYSE:SNP), the two largest components, fell hard and continue to feel pressure.

Going forward we don’t see much change until the FED changes course.

Wish you successful investing in 2014, Blaze Fabry.



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