Guru Strategy: Enjoy China's stir-fry economy, but don't get burned

Investors in the Chinese market are thrilled with their returns. The Shanghai Composite Index is up more than 80 percent year-to-date and is at a one-year high. Hong Kong's Hang Seng index (HSIX) is up more than 40 percent, and the MSCI Emerging Markets index (EEM), which trades at a price-to-earnings ratio of 17.3, is now 25 percent higher than its average P/E over the last five years.

All too good to be true? Many investors believe that they are now riding the economic growth curve that was long predicted for China. But Carl Delfeld (pictured) -- head of global advisory firm Chartwell Partners, which runs and -- says investors may be in for a rude surprise.

It's worth listening to Delfeld. Over the past year, his Seeking Global Alpha Core portfolio has given up only 1.1 percent, while the S&P 500 ($INX) fell 21.9 percent. And so far this year, his Seeking Asia Alpha Explore model portfolio is up 25.1 percent, versus 7.1 percent for the MSCI EAFE.

DailyFinance:The Chinese market has been surging this year, but you say it's not all good news. Why? Carl Delfeld: A great deal of the rise in China is due to the Chinese government's $600 billion stimulus package. The Shanghai and the Shenzhen markets are up more than 80 percent and 95 percent respectively this year. They are among the best performers globally this year and that has also helped other markets such as Taiwan and Indonesia.

What's happening is that the economic rebound has been driven by a powerful source of liquidity controlled by the ruling Communist Party. The government is pumping money into the market and funding it by going to the state -owned banks, which they control. They encourage those banks to increase their lending, by setting lending targets -- so all the banks step in and end up funding the stimulus packages. As a result, the rise in the market has been due to bank lending, and the lack of many viable investment options to put this money to work. The Chinese refer to putting this cash into markets as "stir-frying."

How much more stir-frying are Chinese banks doing this year than in the past?
To give you an idea, bank lending in the first 6 months of this year is greater than all of last year, with about $1 trillion of lending -- nearly double the total loans extended in 2008 -- and those funds are finding their way into the market.

Fueling the rise is that many companies have trading arms where they speculate in the stock market. In fact, some state owned companies have set up separate divisions just to speculate and trade stocks. That's the main reason the markets are up so strongly, and the reason why daily volumes on the Shanghai Stock Exchange are three times the five-year average.

So investors are paying too much for growth?
The MSCI emerging markets index trades at 17.3 times reported earnings, up from 15.4 times last week. Compare that to just over 14 for the S&P 500, according to weekly data compiled by Bloomberg. When developing nations last commanded a premium, the 22-country benchmark sank 54 percent in the next year.

So is it overheated? Some feel that this premium is now justified with banks in Asia, because they are generally healthy compared to banks in developed countries, and there is more growth potential in emerging markets going forward. Using a PEG ratio whereby a market's price-earnings ratio is divided by its growth rate, many emerging markets still look attractive.

Is that also the case in China?
Things are going well now, but the sting may be in the tail. The big question is whether this market rise is sustainable. The banks clearly can't keep increasing lending at the current rate.

So the growth needs to come from elsewhere.
China should be investing stimulating consumption. There is an overcapacity problem in manufacturing. But instead they are investing in the markets. Japan did the same thing in the late 1970s before it imploded. In Japan, it was private companies – banks and places like that.

What the country really wants to do is to move away from investment-led growth and get consumers to be a bigger part of the economic pie in China. But for now, growth is all investment-led, and the stimulus plan only increases that. Net exports are down, and consumption in China is weak, so the only reason behind the market's rise is that the government is leading this. So is it sustainable? I think things will fall apart.

Going back to all the bank lending, what happens down the road when loans become due? Will the non-performing-loan problem that we have in the U.S. be shifted to China?
The question is whether China can respond to a global slowdown, and if it is creating its own financial bubble led by government-led investment and borrowing in order to invest. There was a stunning number I recently read in the Financial Times. It said that 566,937 new brokerage accounts opened in China in just one week at the end of July. The markets are unbelievably strong. In particular, IPOs are off the chart.

How do you see this playing out?
The Chinese leadership has a huge task to keep its bicycle economy moving -- it has long been dependent on exports to the European Union and to America. When the Chinese saw those markets fall -- and they thought those markets would fall off a cliff -- they panicked. Since they depend on foreign investment and markets they decided to stop the fall and stimulate demand. So they stepped in without thinking, and now everyone has to think through their reaction.

One little thing that caught my eye were the recent Chinese GDP numbers. They always have an 8 percent target, but in the latest quarter, China announced 7.9 percent growth. A little strange that it's so close, and I wonder how confident we should be in that number. Of course, that number is reassuring, and it makes the market look good. Mark Faber, a doom-and-gloom guy, says China is the only country in the world that puts out its GDP number so far in advance.

But while China's growth is coming from investment, the government has been talking about a more balanced approach to growth.
Yes, they want to shift to a more balanced growth of exports and consumption. The question is how to get consumers to spend more and drive the economy. The number one thing they have to do to stay in power is generate economic growth and higher incomes. Their legitimacy is based on that, so it's their mandate. That's why China opened up its economy -- but it's having a hard time encouraging the Chinese to spend more so that consumer spending can rise from 38 percent of economic growth to 50 or 60 percent. The Chinese are big savers, and the demographics are not in favor with the aging of the population.

So to save more, they need more people employed, and earning more.
Employment in China has been a big issue, and many workers were losing manufacturing jobs. Migrant workers were leaving the cities to go back to their hometowns. While that has reversed a little, it has to reverse a lot to avoid political unrest.

The biggest challenge is that the urban Chinese are making money, but the rural Chinese, about 400 million people, are lagging behind, creating political tension. What China needs to do is to move rural workers to the export-oriented sector to raise their income and spend. It's easy to forget that China is still a poor country, and in many ways, rural people have no disposable income.

But even then, the export business in China isn't what it used to be.
There is overcapacity here because China's growth has been foreign-based. According to BusinessWeek, AlixPartners recently did a study on manufacturing partners, and what it found was that five years ago, the total cost of a product after it had arrived at a West Coast shipping port was 22 percent cheaper on average for Chinese parts than for comparable American-made parts. But by year end, according to the article, the average price difference had fallen to 5.5 percent because of rising Chinese labor costs. So U.S. companies have to ask themselves if that is enough of a price advantage to outsource. The answer is no.

What about Chinese company earnings? Are they, at least, part of the reason for the market's rise?
The 741 companies in the MSCI Emerging Markets index that reported results since the end of the first quarter posted an average earnings drop of 92 percent, trailing analyst's estimates by 14 percent, according to Bloomberg data. That compares with a 46 percent profit slide for Europe and a 31 percent fall for the S&P 500.

Is there any smart way for investors to now buy into China, if they believe that it has further to go before it implodes?
One way could be to invest in China's H shares that trade in Hong Kong. Some estimate that they trade at about 40 percent discount to the A shares, which are only available to domestic investors in China and accredited foreign institutions for the same companies. So you could buy the iShares FTSE/Xinhua China 25 Index (FXI), which is a basket of 25 of these companies. But if the China story falls apart, FXI and H shares will be hit as well.

But given your view, getting into China right now may not be a wise investment.
It's hard to fight this kind of momentum, but investors need to stay on top of these markets and manage the risk. Be wary of getting carried away with China's emerging bull markets. The MSCI emerging-market index had 13 bull-market rallies of at least 20 percent and 12 bear-market declines of the same magnitude, according to data compiled by Biriny Associates. That compares with five bull markets and four bear markets for the S&P 500 during the same period.

My advice: Enjoy the sizzle, but watch out for the burn. I am keeping my hand on Proshares Ultrashort FTSE/Xinhua China (FXP), the leveraged inverse ETF to iShares FTSE/Xinhua China 25 Index.

Carl Delfeld's Chartwell Advisors operates two ETF Websites, and His book Red, White and Bold: The New American Century will be published this month.

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