We will confess that we are as mesmerized by the spectacular growth of the Chinese economy as everyone else. It is indeed a remarkable performance.
Despite China's amazing growth rate, we have decided to emerge from our own trance and take a slightly closer look at this phenomenon. We are so motivated because we remember other Ten Feet Tall economies. Most recent in our remembrance is the Japanese economy. We will not forget that in the late 1980s, the Japanese economy was universally hailed as the Eighth Wonder of the World. The universality of this recognition, and the avalanche of accolades, occurred as Japan was cresting, naturally. And, as par for the course, Japan then DESCENDED, DESCENDED,DESCENDED. The glory of endless growth and profitability, of soaring equity and real estate prices, was COUNTER-TRANSMUTED into economic contraction, deflation, and asset value collapse, which saw the blue chip equity Nikkei index drop 80% from peak to trough and real estate prices drop IN EXCESS OF 90%. Even today, nearly 20 years after the Ten Feet Tall era, it is far from clear whether Japan has actually emerged from the seemingly endless deflation/depression.
China, of course, is not Japan. However, there are certain outcroppings of what normally portends financial market collapse. Generally, such collapse leads to economic troubles of massive proportions. While we are not necessarily predicting that this will occur in China in the near-future, caution is in order, we think.
The most obvious warning sign is the level of Chinese stock prices. While making due allowance for uncertainties in the accuracy of earnings reports and accounting practices, the following statistics are rather eye-opening:
--the benchmark Chinese stock index (CSI 300) sells at a reported 52x lagging earnings;
--the benchmark index has DOUBLED year-to-date
For comparative purposes, the Nikkei sold at 60x lagging earnings in December, 1989, when it stood at 39,000. Subsequently it fell to 8,000. This 80% decline certainly qualifies as "the mother of bear markets," to coin a phrase.
The U.S. market index sold at 15x lagging earnings in -- sorry about this -- the summer of 1929. It was for this reason that the eminent economist, Professor Irving Fisher of Yale University, proclaimed that "stock prices have reached a permanently high plateau." Of course, Fisher could not know that UNPRECEDEENTED AND INDEFENSIBLE FEDERAL RESERVE INCOMPETENCE would convert a mild economic slowdown into the greatest economic depression in American history, annihilating both earnings and stock prices.
In early 2000, at the high point for American stock prices and at the commencement of a 3-year bear market which brought the benchmark S&P 500 index down 50% (the worst decline since 1929-1932), American stocks sold at the UTTERLY UNPRECEDENTED LEVEL of 45x lagging earnings.
Our inference is: the Chinese stock market is INSANELY OVERVALUED, and is PRIMED for a SEVERE DECLINE. Time frame is UNKNOWN. Speed of decline is UNKNOWN. Distance from current stratospheric level to ultimate peak is UNKNOWN.
Clearly, the risk/reward ratio of the Chinese market has reached deep into LEMMINGLAND. No rational investor would buy Chinese stocks now; any holder would be prudent to significantly reduce exposure.
As for what might be the catalyst for a bear market in China, the answer is as plain as day: YE OLDE CENTRAL BANK RAISING INTEREST RATES. This process is well advanced in China. The PBOC (People's Bank of China) has repeatedly sought to tighten up, via raising interest rates and reserve requirements, and by imposing ever-greater restrictions of loans and investment.
The results: ZILCH. Consequently, with inflation rising to worrisome levels (China, unlike the U.S., DOES have a real inflation problem), the authorities have continued to pile one tightening move on another. These moves have individually been small and cautious, but cumulatively NOT INSIGNIFICANT. If there is a"law" of central bank behavior, it is this: the central bank will tighten until an asset price collapse begins. The more overbuilt the asset price structure, the greater the subsequent fall, and the smaller the ability of the central bank to brake the decline.
The Chinese authorities DO CONFRONT A GENUINE DILEMMA -- unlike our own central bank, whose dilemma is purely a public relations creation designed to allow the FED to pursue its own ideological objective in the face of contravening economic and political realities. The dilemma is this: the ruling Communist Party has deserted all of its ideological positions and today stands for nothing except holding power and milking its position for its own financial enrichment and familial advancement. Essentially, the Party, totally emptied of ideological commitment, is a clique of "ins," structurally very similar to ruling dictators and generals in innumerable countries, who grab up as much loot as possible while enriching families, friends, assorted hangers-on, and those instruments of repression which insure their perpetuation in power -- the military, the security forces, the media, the state bureaucracy.
The Party perceives that, without any ideological underpinning or real fealty from the populace, its hold on power is shaky. Moreover, in the context of rising expectations and rising popular DEMANDS for material goods, the PARTY must meet these demands if it is to rely on something other than sheer force to hold onto power and its LUCRATIVE benefits. A serious economic setback would place the party under serious threat.
The Party's difficulty is compounded by the contradiction between the growing role of the market economy, and the perceived necessity of maintaining key elements of the historical COMMAND ECONOMY of Communist China. This derives ultimately from the profound and unbridgable gap between the requirements of a true market economy -- which is THE PRIMARY SOURCE of China's economic miracle -- and the UNDEMOCRACY of the current "Communist" regime in China.
From the point of view of economic development, there are also certain historical "lessons" to consider. The evolution of western economies from undeveloped, rural economies to industrialized economies, and then sophisticated service-based information economies HAS BEEN PUNCTUATED BY PERIODIC MARKET PANICS AND ECONOMIC DEPRESSIONS. (D word, NOT R word).
Will China prove immune to this course of development?
Since we do not believe in fairy tales, our answer is a resounding NO.
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