How China leads the way for the West
Aug 03, 2009
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Whichever way China goes, so will the West.
Recently, we said that if the FTSE closed above 4,500 we would deem our bear signal to have failed and the future direction of the market to be uncertain. We then said:
"The effect of FTSE's surprising strength is that the bear market [is] at risk. A close a decent bit above 4,600 would suggest a fully fledged medium term reversal from where it might head higher still."
Readers will know that the recent price action for FTSE and other developed world's stock markets is not in accordance with our view. In our opinion, the price over the recent two weeks should have moved down towards 4,000 not up towards 4,600.
We have repeatedly said that the economic conditions besetting the global economy are similar to those that from 1990 punished Japan, and from 1929 punished the US and the rest of the world. So we are going to look at today's FTSE and compare it to the Japanese Nikkei Dow from 1990 and the Dow Jones from 1929.
Initially, all three markets collapsed by 50% and then rallied. The Dow Jones in 1929 rallied 50% of its decline from where it collapsed, the Nikkei Dow rallied 33% of its decline from where it collapsed and FTSE, has so far rallied 33% of its decline - what happens next is critical. We are asked to believe, because of the extraordinary capabilities of Ben Bernanke, Alistair Darling and other financial luminaries, that their responses to the asset market and economic collapse, which they did not anticipate, will be successful and that the bear market has ended. History, however, seems to suggest otherwise.
All three initial rallies were triggered by improved sentiment and clear statements from the authorities that economic recovery was underway. We can actually give you a quote from President Hoover:
"While the crash only took place six months ago, I am convinced we have now passed the worst and with continued unity of effort we shall rapidly recover. There is one certainty of the future of a people of the resources, intelligence and character of the United States – that is prosperity."
He said that at a Chamber of Commerce of the United States dinner on 1st May 1930. We hear very similar words today from Gordon Brown, President Sarkozy, President Obama, et al.
Returning to the Nikkei chart, you will see that after the first failed bear market rally there have been four subsequent bear market rallies, all of which failed. Each one was expected to herald a new bull market – eventually one will, maybe the next.
It is nineteen years and seven months since Nikkei Dow's all-time high of 38,916 and the price is still struggling to stay above 10,000. How long, we wonder, will it be before the old highs are regained? For an answer, we can look at history. The top of the American market in 1929 was not exceeded until 1954, it took twenty-five long years. So on that basis it's probably going to be six more years before the Nikkei is above 40,000.
We recently highlighted Japan as a potential investment opportunity. If, over the next six years it's going to rise above 40,000, it will have to double and double again during which time we will want to own it. We recently said that the tide was going out. If you are standing on the beach watching the sea, it seems that whatever the tide is doing, the waves look the same; they come in and go out. However, part of the time, the waves make higher highs and eventually the tide is fully in, at other times they make lower highs and eventually the tide is fully out. But unless you carefully study each wave relative to the previous one and the next one, you can easily be deceived. So, in pursuing that thought, the rally to current levels is probably no more than a wave coming, but the tide is still going out.
On Wednesday, the Chinese stock market closed down a big 5%. This situation is of particular concern because we hold a position in the Fidelity China Focus Fund, which has done very well since purchased but, given the sudden volatility, may be threatened.
The Chinese economy (and its stock market) has been perceived as the global leader. It started its considerable rise at the end of October last year and from March most other stock markets had joined it. Since last year, the journey of the Chinese stock market has been relentlessly up, almost too extraordinary to believe.
Now cries of "bubble" are being heard and recent news suggests considerable precariousness. The latest news concerns that good old bubble creator, excessively loose credit.
For the first and second quarters of this year, China's credit expanded by 30% pa compared to 2008, causing the Chinese regulator to order banks to ensure that all new loans are channelled into the real economy and not into equity and real estate markets, where they say fresh asset bubbles are forming. The press are saying that the biggest Chinese banks are to shut down lending for the year. In recent years, total loan growth of about 15% pa supported GDP growth of more than 10% pa. This compares to the first six months of 2009, where the total loan growth was 33% pa, supporting GDP growth of only 7% pa. The kicker is this: the quality of lending has deteriorated – sub-prime anybody?
If it is at least partly correct to say that the tentative economic recovery and surge in stockmarkets from March has been led by China, what will happen if the Chinese stock market dramatically retreats? We think that the world will follow China down. So what we need to do, is take a cautious approach to the Chinese stock market investment and possibly sell on further weakness whilst decent profits are to hand. So what about the Bear Note? Our conviction is that this is maybe where you buy it, not sell it, although we will constantly reconsider this in case we are wrong.
The recent improved sentiment and market action has been generated by financial largesse - governments' expansive monetary policies - not by revived bank lending. Unless banks start lending to households and smaller and medium-sized companies, no recovery is sustainable and bear markets will resume. Unless companies big and small do more than just report improved profit compared to analysts expectation, achieved primarily by cost cutting, but instead increase gross revenue, there is no hope. All of which points to the underlying reality which is that the tide is still going out.
• This article was written by Full Circle Asset Management,
as published in the threesixty Newsletter
on 31 July
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