Everyone Please Remain Calm-It Was Just a Correction

If last week taught us anything, it is that many of the world's most liquid mature equity markets have started taking cues from China, be it justified or not. Previously, the vast majority of people agreed that, given China's unquenchable hunger for resources, China was a significant player in determining world commodity prices (i.e. steel, oil). People also largely agreed that China was in many ways responsible for holding US interest rates down due to their feverish purchasing of US Treasury Bills. Yes, those of you in the US that took advantage of the low interest rates and refinanced your homes in the past few years, you have China to thank whether you want to admit it or not. China's buying of US T-bills has less to do with their attractive investment returns and more to do with keeping their own currency weak relative to the US dollar enabling their export engine to keep running. Keeping US interest rates low is in China's interest, because it keeps US consumers purchasing goods that China exports. Continued export customers keeps China's factories humming and employment up, something critically important in a country that must maintain over 7% economic growth annually to create enough jobs for new people entering the work force annually.

There has been chatter that China, in addition to many other nations (i.e. cash rich Middle-Eastern countries-->price of oil per barrel is denominated in US$), are looking to diversify their FX holdings into other currencies and/or gold. Currently, China holds over $1 trillion in US T-bills. No, that is not a typo. If I'm a market speculator, I'm definitely betting that gold is going up. The economics just make sense. If these countries do indeed choose to dump a percentage of their USD holdings in favor of other currency's or gold, expect US interest rates to jump and money not to come quite so cheap in the US. Adios, to the low financing of the new car.

The events of this past week warrant some consideration. We must ask ourselves, how does an 8% drop in a stock market (China's A-share market) that was among the world's worst performers in 2004 and 2005 and is coming off a year during which it increased 130% send such shock waves throughout the world? The following day, the Dow was driven down almost 4% and other indicies around the world took it on the chin as well for no real reason at all. After a 100+% rise in the China A-share market over 12 months, isn't a slight pull back justifiable, even expected?

Before 2006, the rest of the world didn't care what was happening on China's stock market. It was what many considered to be a casino. Maybe this is what was necessary for people to finally take notice or acknowledge that they already knew subconsicously. Officials have openly stated this year that over 70% of the listed stocks on China's A-share market are worthless and should be delisted. Granted, things are getting better, regulations are beginning to be enforced and more quality companies are starting to list in mainland China, but China's financial infrastructure has a long way to go. A country might be able to build highways and bridges in 20 years, but instilling the concepts of intrinsic value, corporate governance and regulatory enforcement take time no only to implement but to educate people as to why they are necessary for a well-functioning market.

My guess is, this won't be the last "pullback" China's market experiences. I believe there were actually people in China breathing a sigh of relief as the government has been working very hard to find ways to cool the already overheated market. The question is, how will the world react when it happens again, and believe me, it will. That is the nature of an emerging market.

I think we should stop pondering whether or not there is a connection between China's equity markets and the rest of the world or if the aftershocks are justified. Rather, it would be better to accept the fact there is a perception of a connection ingrained in peoples' minds. As one of my coworkers accurately stated, "fear and greed" drive the market. In the end, I think most people think there shouldn't really be a correlation between what happens on China's markets and the rest of the world, however, they "fear" there just might be, and that is enough to cause a panic.

Long lines, forgotten passwords, and all-star mother-in-law money managers-China's Investment Environment

If you spend enough time in China, you learn fairly quickly the "herd mentality" abounds. It is evident everywhere, restaurants/ticket counters/kiosks/brokerage lines/ect. The Chinese are big believers that where there is a line (or crowd), there must be something worth waiting for or worth seeing. Maybe this is why there constantly seems to be droves of people pushing to get "an edge." Receiving a shove in the back is never personal, it is just a friendly reminder that you better pay attention, because someone is there to capitalize if you don't. It is a real "hustle" attitude which fits nicely with the idea of free markets and "no free lunches." It matters less if there is really an substance behind what seems to be so sought after, rather the perception of substance is enough to draw crowds. At Starbucks, are coffee beans, hot water and a frothy top really intrinsically worth $4? Maybe not, but that is irrelevant. The marketing folks at Starbucks have done a text-book job of convincing people it is worth the price.

After lingering in the abyss since 2001, China's A-share stock market returned 130% to investors and speculators alike in 2006 making it the best performing market in the world. The A-share market is already up another 10-15% in 2007. Now, do the companies behind these stock tickers actually justify such valuations? It is hard to say for sure, because reliable company financial data is extremely hard to come by in China. If one cannot trade based on reliable fundamentals, that only leaves one option: technical trading.

Stocks in China are largely traded a physical brokerage locations or over the phone. Online trading is still relatively new in China, but will likely gain traction in future years. Due to the "can't miss" investment opportunity that is the A-share market, local Chinese are rushing to open accounts at breakneck speeds to get a piece of the action. By some estimates, as many as 70,000 new accounts are opened daily. With the release of Qualified Foreign Institutional Investor (QFII) regulation last year, foreign investment capital was allowed to flow in to the A-share market for the first time.

While foreign individuals (such as myself) are not allowed to open brokerage accounts in China, a quota of approximately $11 billion allowed to be invested in China's stock market was spread across 50 foreign institutions. Billions more is waiting at the door itching to rush in. Given the fact there is already excess liquidity sloshing all around China and, in the interest of not having the market spike 1000%, the flood gate will be opened slowly to foreigners. Historically, most Chinese lacked many investment options, as the average "Joe" or "Li" isn't allowed to invest abroad. Average people could choose to leave their money sitting in a bank account (where approx. $2 trillion sits today) earning 1.5% or take their chances in the local equity markets. Presently, the equity markets are perceived as more legitimate than before as better quality companies are choosing to stay at home a list locally, taking advantage of the liquidity, and regulations are being more actively enforced. Almost 1/2 of the companies listing in Shanghai last year, were already listed abroad in markets like Hong Kong. As a result of the perceived value, regular people are getting in.

I sometimes hear local people complain they had an off year because their portfolio only returned 70% in 2006. Granted, they missed replicating the overall index, but there are people running hedge funds and investment firms all over the world that would call a 70% a better than average year.

At a dinner I attended the other day, a Chinese friend (who had spent 5 years abroad) told me how nervous she was investing in the local market. She told me last week she made a trip to a local brokerage house to execute a trade. While she was waiting in line, a man, who by her estimate was around 80, starting flipping out. During the 1990s this would have been interpreted as normal, because brokerage houses in China were the equivalent of bingo halls in the US. They were a place where retired people went to pass the time and throw some money around never really expecting a return. To them, it was the price of entertainment.

As it turned out, he was throwing a fit because he had forgotten the password to his brokerage account, so he couldn't make the trade he wanted when he wanted. Her words were, "if he is representative of who is investing in the market today, things are getting way out of hand." The present investment environment in China is symbolic of the mania of the late 1990s that swept across the US. Many people said, once my barber starting getting into the tech game, they knew it was time to liquidate. Maybe we should tailor that statement to read, "once the 80 year old guys forgets his password and flips out in the brokerage house, it is time to get out or at least take a knee for a while."

One of my coworkers' mother-in-law is managing a portion of he and his wife's money. Now, it would be one thing if she was an experienced trader or money manager, but she is neither. She doesn't even know what company financial statements are or anything about investment multiples or sophisticated analysis techniques, which might be just as well given local conditions. Her investment strategy is "never invest for the long term in China's stock market." This might sound crazy, but it is highly logical given the volatile roller-coaster ride that epitomized China's markets during the 1990s. She returned in a measly 35% return last year because, in his words, "she's too conservative." I advised my coworker to fire his mother-in-law as his money manager and run down one of the 80 year-old guys down at the brokerage house to take over, preferably one that can, at least 7 times out of 10, recall his/her password. He thought that wouldn't be a good move given the "probable less than desirable implications on the home front."

Moral of the story: well, there isn't one. It is just a very interesting time in the wild wild east where long lines, forgotten passwords and all-star mother-in-law money managers tell you all you need to know about the state of the local markets.

Starting from the Middle

It is only fitting that this blog should begin this way-in a illogical (at least to the Western mind) fragmented fashion. Actually, most of my favorite movies start in the middle and follow the story line until the end. It is only in the prequel, that shows up in theaters 2 years later, that we actually find out what happened in the beginning. Maybe the beginning matters less than the journey in the middle and result at the end.

Instead of logging onto Blogger and creating a blog in 5 seconds as advertised, unanticipated challenges have already presented themselves. The entire site is in Chinese. Typically, when someone doesn't understand something or is totally lost, they might say something like "this might as well have been in Chinese." However, having studied Chinese for over 5 years now (when I can clearly remember 5 years back I feel like old, or at least older. Maybe it is at the point when I cannot remember 5 minutes ago that I am in fact "old"), I have to tailor that statement to read something like "this might as well have been in Java or Arabic." I do read some Chinese, but things would have been a lot easier had it been in English.

These challenges are fitting because it is in a sense a microcosm of challenges and confusion faced everyday by foreigners running around China. Take traffic for example. One would be hard-pressed to find a more dynamic scene than an intersection in China. There are cars coming from every direction, taxis leveraging for position, guys are on bicycles smoking and talking on a cell phone while transporting mounds of "stuff" (which is actually quite impressive), people are eating, talking, squatting, spitting; it would appear to be a very chaotic. However, mysteriously there are fewer wrecks, accidents and miscommunications that one might think. I guess if everyone assumes everyone else is not going to follow traffic rules, there is an element of anticipation built into everyone's head. Where foreigners see chaos, the Chinese see normality and logic.

I am going to save elaborating about how I got to China. Like my favorite movies, this blog will pick up in the middle of my time in China. Maybe I'll be able to shed some light on the whys and hows of my ending up in China along the way. My intention is to act as somewhat of a bridge for people interested in knowing more about this dynamic place through the lens of my day-to-day life. Lessons about how to make sense of China can be found everywhere: buses, airports, on the street, in tea houses, in cabs, in line, ect. I welcome you on this journey as I continue on the trajectory of trying to sort out the Chinese intersection. I am off to a Chinese wedding, which should afford me some interesting things to share later.