Scoops Lane
Tuesday, 13th May 2014
By Kris Sayce, Melbourne Australia

  • Riding Goliath, Viper and Tatsu
  • Rich versus poor
  • Let there be money

Riding Goliath, Viper and Tatsu…

Still worried about rising stock prices?

Don’t be. A rising price can’t hurt you…but the fall can.

Last night the Dow Jones Industrial Average closed at a new all-time high of 16,695.47 points. It was a gain of 0.68% on the day.

The NASDAQ Composite Index, which has had a torrid two months, gained 1.77% to close at 4,143.86 points.

It’s now only 200 points below the multi-year high that it hit in March.

As for the Aussie market, this morning stocks loved the overnight rally. It was up as much as 56 points in early trading today.

It’s now back to within a sniff of April’s high point. That in itself was the highest level since the market started cracking in mid-2008.

What’s going on? What happened to the fear? Isn’t May the month to go away?

Apparently not. Small-cap analyst Tim Dohrmann swatted away that old chestnut in a recent Money Morning article. You can put the ‘sell in May’ argument in the same rubbish bin as presidential cycle theory, election year theory, and rabbit’s foot charms.

None of them will help you make even one bean in the stock market.

The simple fact is that stock investing is all about investor psychology.

It seems illogical, but when stock prices go up, investors start to become agitated. The euphoria mixes with fear. It creates a volatile situation where investors panic and react to potentially minor and unimportant events.

I’ll give you an example.

Three weeks ago during a family holiday to southern California, we went to the Six Flags Magic Mountain roller coaster park. It’s about a 45 minute drive north of Los Angeles.

You get a spectacular view of the Angeles National Forest and red-tinged mountains and hillsides.

But that’s not why you go to the Magic Mountain roller coaster park. You go there for the roller coasters, such as Goliath, the X2, the Viper, and Tatsu (seven loops, no less).

I can’t claim to be a daredevil when it comes to roller coasters. But I’ll give almost anything a try.

However, I’ve noticed one thing riding on these roller coasters. While the whooshing and spinning and flying around and upside down is exhilarating and thrilling, it’s not necessarily the most nerve-wracking part of the ride.

For me, the most nerve-jangling aspect is the slow grind to the top. In the case of the Goliath ride that’s a 72 metre climb.

But why would going up jangle the nerves? That’s obvious. Every metre that you climb, that’s one extra metre that you have to descend…at a much faster pace.

For the Viper ride, following the 72 metre climb, you head straight into a 78 metre drop. Don’t worry, the ride doesn’t slam into the ground, it goes into a tunnel.

It’s the same with stock investing. When stocks keep going up, up and up, investors start to panic about the chances of the stocks going down, down and down.

They begin to close their eyes. They don’t want to see what’s happening. They start to imagine that someone’s going to ‘pull the bolts’ out of the stock market’s infrastructure.

They’re worried that the ‘stock market car’ will fly off the rails the second it hits the top…and that their whole portfolio will burn and die in a financial fireball.

In a way it’s a perfectly rational reaction when you consider the recent history of the 2008 meltdown.

But in the same way it’s perfectly irrational. 2008 was a big event, perhaps the big event. It was the culmination of decades of central bank and government manipulation. It wasn’t — as some still think — the result of the stock market hitting the top in 2007.

The stock market top itself was a result of the same decades of manipulation. Is it possible that governments and central banks have recreated or resumed in just five years the same problems that led to the last crash?

Anything’s possible. Whether it’s likely to happen now, within the next few days, weeks or months, is harder to say.

But what we do know is that after months of fear as the market continued to rise, followed by weeks of angst as it fell (especially tech stocks), today the market is brushing off these fears.

Does that mean we’re back at the bottom of the stock roller coaster before it begins its ascent? Or has it sucked in investors who thought that the big drop was over…only for a bigger, steeper and more severe drop to follow soon after?

Who knows? But when the market sees good news it tends to react positively.

Yesterday China’s CSI 300 index gained 2.2%. If you follow the Chinese market you’ll know that it has pretty much gone through the crash that our old pal Greg Canavan predicted nearly two years ago.

Since early 2013 China’s stock market has fallen 21%. And it’s still down 61% from the 2007 peak. That’s worse than the Aussie market, which is now only down 19% from the 2007 peak.

The big spur for China’s rally yesterday was news on capital market reforms. We asked emerging markets analyst Ken Wangdong for his take on the story and whether there was any justification for the market to climb 2.2% yesterday.

Here’s what he told me:

The latest capital market reform blueprints are a continuation of the old reform agenda from 10 years ago. On the surface, the guidelines rehashed much of the old ‘National Nine Guidelines’ (as the guidelines are called in Chinese), there were a number of detailed items, dates and pivots that you need to be aware of.

The new guidelines specified in its ‘recommendations’ section: improvements in providing information transparency during share issuance; protection of investor interests in M&A, buybacks and delisting activities; and a strengthening of regulation and control in listing, delisting and relisting activities.

The guidelines also outlined specific deliverables and a timeline for moving forward the IPO registration reform; so a new IPO registration system will be in force by the end of 2015.

The long term impact will be positive, as it should mean greater investor protection, information transparency and more IPO activities in the market. A greater supply of companies should also ease the current shortage in China’s equity market. Right now there is too much asset concentration in a number of key sectors.

However, in the short term performance of the Chinese (and related) markets will continue to be driven by broad economic developments.

I’d say you can read between the lines on this one.

It broadly means the Chinese government wants to attract more investment, whether that’s domestically or internationally.

In a way you could say it’s an attempt at an indirect stimulus. Anything that eases restrictions on making investments can only be a positive for potential investors.

No wonder Chinese stocks piled on a 2.2% gain.

You can read more from Ken below in his article ‘Rich versus Poor’.

But China wasn’t the reason US stocks piled on the gains overnight. The news there was more to do with the idea that the US economy is in full recovery mode.

Believe that if you will.

But whether you or I believe it or not, most investors seem to believe it, and stocks went up.

As Bloomberg News reported:

About 76 percent of the 453 S&P 500 companies that have released results this earnings season have beaten estimates for profit, while 53 percent have exceeded revenue projections, data compiled by Bloomberg show.

Profit at the companies will probably rise 7.2 percent this year, as sales will climb 4 percent…

Three-quarters beating profit estimates is pretty good. Although I’ll admit that the revenue projections weren’t quite as good.

Even so, this along with a push by investors in tech and small-cap stocks was enough to push up the NASDAQ Composite index by 1.77% and the Russell 2000 index of smaller company stocks by 2.39%.

Are the problems over?

Is the world economy back on an even keel, ready for spectacular gains as stock markets everywhere hit new highs?

Hopefully.

Will it last forever? Of course not. It’s the stock market. It may not even last through the end of this week! It’s like the roller coaster ride.

But boy, if stocks are set to resume the bull market run you’ll want to make sure you’re in position to benefit from it. Tech stocks especially right now are looking ripe for the picking.

Cheers,
Kris+

Rich versus Poor

By Ken Wangdong, Emerging Markets Analyst

You should always watch three indicators closely if you want to detect potential dangers in the Chinese economy.

They are: property price to income, pollution, and income inequality.

These three indicators immediately affect ordinary citizens in their daily lives. They inflict economic, physical and psychological pressure on the society, and they can be dangerous sources of instability for China’s ongoing success.

We’ll touch on China’s wealth inequality today. It’s an issue that’s at the heart of China’s structural reform.

Greater inequality is a result of the problems in the existing economic model. It will need to be addressed if China is to shift successfully from an investment, export-led model to a consumption-led model.

Let there be money

How did China transform from a communist country where people received food stamps instead of currencies to a state-capitalist society that takes pride in its own greed?

You can trace the answer back to Deng Xiaoping’s early reform agendas. After almost three decades of stagnation, due to periods of war and domestic turmoil, Deng was ready to launch China on a path of market reform. His famous saying, ‘we need to let some (people) get rich first,’ firmly put China on a path to deviate from the communist ideals of China’s former master, Chairman Mao.

Deng’s way was to have far reaching ramifications until the present day. China has now reached a potentially dangerous level of inequality.

Just how bad?

Just how bad is China’s growing wealth inequality? The Gini coefficient measures inequality numerically. With 0 being complete equality and 1 being maximum inequality, China is at 0.55, doubling from 0.30 in 1980. China is ahead of the US, which has a score of 0.45.

Inequality can vary based on geographic locations, gender, age and other factors. To generalise, most people in China are poor and earning a minimum wage. There is a rising middle class with around three to seven times more income than the poor group. And then there is the upper-middle class with anything up to 20 times the monthly earning of a person in the poor group.

The rest can be considered as rich. However, there are obvious different income categories in the rich list as well.

Why does this matter?

Two reasons: first, China needs a larger middle class to shift to a consumption-led model. Second, pressure on the livelihood of those in the poor group can be severe. Combined with a sense of resentment towards the richer, this produces social instability.

How do people live?

The truth is despite China’s growing wealth inequality, the majority of the poor group has been able to get by just fine. How? Because things are cheap in China.

China operates in what I call a ‘low cost commerce’ model. The vast urbanised population has kept labour costs low. The banking system has subsidised provincial governments, infrastructure, SOEs (state owned enterprises) and private investments at large.

The shadow banking system has been particularly active in supporting real estate, short term and medium term credit facilities, private companies and small businesses. The energy market is regulated and prices are kept artificially low. Heating is subsidised in some cities. Infrastructure is financed by the state and prices of transport are artificially low. 

There have been a few developments in China that have made this ‘low cost commerce’ model work. Increasing competition in all areas of consumer goods has driven down retail prices. The coming-of-age of China’s commodity and light industries has meant lower prices in consumer goods and industrial goods in China.

The growth of services has meant lower prices in all service sectors over the medium run. Productivity growth, income growth and investment growth have meant higher income for citizens, relative to the cost of goods and services.

We have seen substantial growth in the real purchasing power of citizens. This has led to a higher quality of life for many. This is precisely why there has not been much social instability in the past 30 years, until now. (Incidents such as Tiananmen Square were more about corruption, political rights and a desire for a more democratic system.)

At the heart of a consumption-driven model

China’s wealth inequality issue is as much a threat as it is an opportunity. A solution to the problem will unlock huge potential in our group of poor consumers.

There are a few basic ways you can achieve better distribution: taxation reform, banking system reform, Medicare reform, social security system reform, Hukou (citizen registration) reform, minimum wage reform, and urbanisation in developing regions. 

Essentially, urbanisation in developing cities should boost income, services and consumption in their regional economies; taxation reform and banking system reform should redirect more capital towards savers and consumers; and Medicare, social security system and minimum wage reform should boost disposable income.

Stability, stability, stability

The latest industrial strike in Yue Yuen [HKG:551] — a manufacturer for Nike and Adidas — and the terrorist attacks in Xinjiang are reflections of the growing inequality problem. On the surface, the two incidents occurred due to non-financial reasons. The first was due to management inadequacy and the second was Islamic terrorism.

However, having spent time in both Dongguan (where the factory is) and Xinjiang (where the bomb attack happened), I assure you the problem is deeply rooted in the distribution of wealth.

In the first case, it’s the combination of poor worker treatment and low wages that pushed workers towards a strike. I have experienced such conditions in China first hand.

The issue in Xinjing is similar to the anti-Chinese sentiments in Malaysia and Indonesia (relative deprivation). Chinese Han (the majority of Chinese are of Han race, as oppose to Uyghur in Xinjiang) took over power and set up businesses in the region, alienating the local race. There are a total of 56 races in China.

Wealth inequality is a key indicator to watch if you want to assess China’s progress. If China urbanises further and reform programs are adopted, you’ll see a reduction in the Gini index. This will mean more consumption in the medium run and consumer related stocks should do well.

If China fails, you will see more instability in all regions over China. Stocks that target the ‘poor group’ should do well, and stocks that target the ‘rich group’ should do well too. However, in the latter case, you can expect more disruptions due to strikes, violence and crackdowns.

Regards,
Ken