Last week – before we set about proving that Australian housing was a bubble waiting to blow up – we began making the case that the resource boom might be facing an unquestioned assumption behind its enduring boom: that China won’t blow up. But what if it does?
There is emerging evidence that China has its own enormous property boom. The fortunes of provincial governments are tied to land sales. So real estate has become a real rice winner in terms of government revenues. But to be honest, that is not a story we’ve investigated much.
It’s Australian resource stocks that are our beat here. And it seems like if China’s demand for raw materials is driven by an unstainable level of fixed asset investment (short-seller Jim Chanos says China is on a “treadmill to hell” with 60% of GDP derived from construction spending) then the rosy assumptions about rebounding exports (and the royalties that heal damaged federal finances) are pretty stupid and short-sighted assumptions.
Luckily while we were over in Perth talking about how to be free in an unfree Australia , our man in Sydney, Greg Canavan, had his thinking cap. Greg’s new venture, Sound Money. Sound Investments, combines a big picture perspective with a kind of a forensic analysis of the balance sheet and some time-tested methods of valuation. He sent us a note on China’s perceived strengths and weaknesses over the weekend.
He writes that, “Most people point to China’s huge foreign exchange reserves as a source of wealth and firepower to deal with any emerging problems. As I’ve stated in previous reports, I don’t agree with such an assessment. Why?”
“China based economist Michael Pettis says that only twice before in history have nations built up foreign exchange reserves similar in size (as a proportion of global GDP) to China’s current hoard. Those two lucky countries were the US in the late 1920s (despite Britain’s attempts to stop the US accumulating gold) and Japan in the late 1980s. Pettis says rapid expansion of domestic money and credit were responsible for these two countries’ subsequent malaise.
“‘It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.’
“This doesn’t mean China will suffer a decade or so of deflation and falling asset prices. But it does mean you should be cautious about the country’s prospects and the expected impact on your investments. At a guess, I would expect China to feel the effects of much slower credit growth and lower government involvement in the economy by the final quarter of the year, if not before.
“None of this expected risk is priced into the Australia equity market at the moment. And that is not surprising. All we hear is how the Chinese are on the hunt for resource projects, and how demand for steel inputs is going through the roof. But that demand is the result of past stimulus.
“Meanwhile, inventories of most base metals are at or near their peaks (and above 2008 peaks) suggesting that basic raw material supply is more than adequate to satisfy demand. After all, the global economy is only just emerging from recession and is not expected to bounce back strongly.
“The biggest concern for Australia is that China has brought forward much of its raw material demand via the 2009 stimulus measures. When the impact wears off, commodity prices may correct and give back some of the very large gains achieved since the 2009 lows.
“For this reason I am avoiding the resource sector until prices move back to more favourable valuations. This may take months, and I may look like an idiot in the meantime, but my view preservation of capital is more important than jumping on momentum trades.
“When the inevitable correction comes and good value appears, I look forward to making some quality recommendations. I’m not predicting China to endure a nasty, drawn out depression like the US and Japan experienced previously. But it will go through a post credit boom hangover. The result will likely be another round of extreme equity market volatility. Be sure you have cash on hand to take advantage.”
Incidentally, Slipstream Trader Murray Dawes would probably be sympathetic to Greg’s view. Murray put out a new trade yesterday in which he said, “I have been banging on for a while about my feelings that the market is entering a sell zone and I think it’s time to start playing the market from the short side.
[Deleted] has sent a sell signal on the false break of the January highs of $ [deleted].”
Obviously we can’t tell you what trade Murray recommended. But we would like to point out that if you don’t have a macro view in this market, you’re going to get blindsided. And having a bearish macro view doesn’t mean you can’t make money. Murray writes that, “I see this position as a way to get short the market as a whole because I believe the index charts are all pointing to some weakness dead ahead. The ASX200 in particular is today looking close to confirming a false break of the January highs of 4,955 after touching the 50% retracement from the crash.”
Greg has a macro view. And his strategy is to avoid the correction and have enough cash to take advantage of the values when they emerge again. That sounds sensible.
Do I contradict myself?
Very well then I contradict myself,
(I am large, I contain multitudes.)
Walt Whitman, Song of Myself
It’s important to remember that no one knows what the market is going to do. We were asked recently by an interrogator if publishing seemingly contradictory positions on the stock market was..well…contradictory. Shouldn’t we be consistent?
We explained that is was not our primary mission to be consistent. That means sticking dogmatically to a view because you’re too stubborn to change your mind. Or, in the case of investment advice, because your business has a vested interest in promoting a certain outcome or view point.
Our business is to find and publish intelligent and well-researched ideas about how to make money in the stock market. Smart people often disagree. And we see no reason to try to arbitrate their disagreements. We don’t know who’s going to be right.
But we do know that it’s better to have hard-working people beavering away on their best ideas in their chose areas of expertise, and then to let the market decide what works best. This way, you have a portfolio of well-researched views and ideas from real independent analysts who are not serving any other interests.
And when it comes down to it, how and if any of these ideas fit in with your own financial plan is ultimately up to you. A free, thoughtful, and financially independent person wouldn’t have it any other way.
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