Monday, May 28, 2007

A Bull in the China Shop: The Fundamentals of the Worldwide Share Rally

We're in the midst of the biggest bull market in history. Virtually every asset class has been yielding double-digit percentage gains annually. Here in the United States, the boom is less obvious. In Asia, it is unmistakable and profound. Since this is a blog post, not a book on economic history, I'll try to keep my commentary on this world-changing transformation brief. In particular, we'll go back to the subject of China, which I think will be the defining story of the next century.

Pundits cite numerous reasons for the boom, the foremost of which is a liquidity glut. One explanation for the "easy money" says that as Asian and Middle Eastern nations receive US dollar payments for their trade with the United States, and they have enormous trade surpluses ($1 trillion in China's reserves so far), they are inclined to re-invest that money in dollar-denominated assets to avoid driving up the value of their own currencies. This buying pressure on T-bonds and T-bills leads to decreased interest rates and easier credit for business expansion worldwide.

The general idea is that lower interest rates make borrowing cheap. And who wouldn't borrow at 6% in order to invest in a business with a cashflow over 16%? That's a low-risk return of over 10% annually. Now multiply it times 4 using leverage (40% return), and you have a high-risk hedge fund or private equity fund at your finger-tips.

China alone is growing 10% per year. Many of its businesses are growing earnings 20-30% annually for the past 5 years, as evidenced in the China Stock Directory. Yet the Yuan is pretty stable versus the US dollar, so currency risk is low. Private equity funds can make a killing by arbitraging this type of interest rates to earnings differential. Makes sense that the Chinese government is a pre-IPO investor in Blackstone -- Blackstone gets preferred access to fast-growing Chinese companies, and China gets the know-how to set up a domestic private equity industry.

So there is a fundamental logic to the boom - that's my point anyway. But since this is an investor psychology blog, how can we know when bubbles form on top of booms? In particular, is China in a bubble? Some say that a PE of 42 for China Communications Bank is high, especially when HSBC has a PE of 13. Does a high PE alone mark the top of a bubble? Greenspan used the high PE = bubble logic when he insinuated the US market was irrationally exuberant in December 1996. His timing was way off, but it does have a historical logic.

In my studies of sentiment, tops are usually marked by high optimism. But so are the rallies on the way to the top. If you shorted every period of 2 standard deviations above average optimism over the last 20 years, you'd have zero returns. No matter how pessimistic you are, you have to admit that shorting optimism does not work without other objective criteria to go by.

In April, 5 million new stock brokerage accounts were opened in China. That is 2/3 more than were opened in all of 2006 (per the Economist magazine). That sounds like an investor frenzy. But guess what - they shoud be excited. China has been booming for 20 years, and the tipping point has finally been reached where domestic Chinese investors can chase hot stocks. It's healthy that people are getting involved. Does that mean they will emerge unscathed? No.

When will the psychology of the Chinese bubble become a problem? As I mentioned in a previous blog post, probably not until next year. So far the share prices have been rallying less than two years. While PE's are high in big name stocks, there are still some bargains in China(granted, many with murky accounting).

Even after last year's rally in the US (modest as it was), my stock screens found more cheap small-cap stocks this December than at any time in the past 3 years. And they are up 30+% since then. A rally does not prove a bubble, but it is necessary to one.

So the Asian economic boom is finally being followed by a real stock market boom (China and Vietnam in particular). This is good news, as it means their financial systems are globalizing. The selloff of May 2006 indicated that while some investors were skittish about the huge recent gains, the general trend remains extremely positive. This year is no different from 2006 in terms of economic growth in Asia, except that investors are finally catching on and assets are at or exceeding their fair values worldwide. Yet, they can certainly go further. There will be scary selloffs along the way (probably very steep), but they will be clearing the air for the next rally. Those are my thoughts at the moment. They may change at any time, as flexibility is the paramount virtue in the markets.

Next post we'll look at some recent neurofinance studies.


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