China warning signs coming fast and furious

Posted by: Aaron Pressman on October 24, 2007

China’s stock market has almost tripled in value so far this year and investors across the globe are starting to get antsy. Lauren mentioned last week that a bunch of advisers said it was time to get out and I started cataloging the immense backlog of Chinese companies seeking to tap the U.S. market with initial public offerings. Today, we’re suddenly in very good company.

The Oracle of Omaha and greatest investor of the past few generations, Warren Buffett, says everyone should be cautious given the extreme run up. He’s already sold off his giant position in PetroChina Co. (Symbol: PTR). “We never buy stocks when we see prices soaring,” Buffett told reporters while on a visit to northeastern China today, according to a Bloomberg report. “We buy stocks because we’re confident of the company’s growth. People should be cautious when they see prices rising.”

Certainly, it’s prudent to cut back any obvious China plays in your portfolio. A 5% position at the start of the year in the $9 billion iShares FTSE/Xinhua China 25 ETF (FXI) might now be up to 10% of your portfolio and should be reduced. The tougher question, though, is figuring out what secondary damage might be inflicted by a Chinese stock debacle. We only have to go back to February, when a big drop in China prompted a 416 point drop in the Dow Jones Industrial Average.

But the harm to the U.S. market, at least in February, was only temporary. Others could be hurt more deeply by a China crash. The most likely candidates for serious secondary damage are the surrounding economies in Asia that have benefited from China’s growth as well as the worldwide commodity markets driven up by ever-growing Chinese demand for raw material. Be careful, too, with general emerging markets fund. Over 40% of the $25 billion iShares MSCI Emerging Market Index ETF (EEM), for example, was invested in stocks of China, South Korea, Taiwan and Thailand as of the end of September. And as an unmanaged index fund, there’s no one steering the ship there to trim back that exposure.

Money manager Roger Nusbaum had a useful post the other day explaining how he’s tried to craft a position in emerging markets stocks while reducing exposure to the possibly overheated China sector. He prefers Brazil. Any other good ideas out in the blogosphere?

Reader Comments

shirish kokatay

October 24, 2007 2:33 PM

The potential for excess in enthusiasm, a polite way of saying greed, is exponentially more in China than in USA. Here we have powerful watch dogs, such as SEC etc keeping a eye out for signs of out-of-the-ordinary occurences. In China such institutions are fledging and not yet up to the task of controlling market gyrations/ manipulations. The coming crash there will make the one here in Oct. 1987 look like a walk in the park. Buyer Beware.

chi

October 24, 2007 6:47 PM

Buy FXI puts 6 months out then wait and watch. If you missed the upswing there is still time to profit from the downswing. If anyone tells you China is safe till 2008 olympics......just laugh and walk away.

ghostgu

October 24, 2007 8:39 PM

I don't think so,please have a look at the price of the most stocks.Even the index soared,most the price on the downhill.

yuen WG

October 24, 2007 8:41 PM

For your viewing regards China

Rajesh Bansal

October 25, 2007 1:25 AM

I think with 1.5 trillion Dollars Chinese government has all it needs to stop a potential crash in Chinese stocks. And all the investors know it because Chinese government has a lot more on stake in the stocks. A sudden fall could have much more effects politically. I think we have 6- 8 months more before we actually see a crash and market can go upto 10000 before June next year and after that I wouldn't bet on Chinese market for coming 2 years.

vivek saxena

October 25, 2007 4:16 AM

Last week I was reading a news item which was comparing stock indexes growth in different countries in Asia and how many years it took to reach at peak. Every economy has its own cycle and growth potential. When we say that it is time to reduce exposure in China as it has grown more that three time this year, should we also not quote other economic and political indicators? Also why do we need to go back to 87 and blame SEC. Enron is more recent. If one says that US has powerful watchdogs then Enron, Worldcom would not have happened. it is difficult to blame watchdogs when there is a collussion of interests. What if we start comparing a stock e.g. Google with a country's stock index.

andy

October 25, 2007 9:37 AM

people should try not to scare others.
if someone wants to have an opportunity to invest in the world's fastest growing economy they can

Kenny Landgraf

October 25, 2007 4:48 PM

Yesterday we learned Merrill Lynch was writing down $8.4 billion (WSJ 10/25/2007 - that is 8,400 million) in mortgage related securities. I find myself asking how we got to this point? Didn’t anyone see the housing bubble coming? Haven’t we learned from history? And, the biggest question: what will be (or currently is) the next bubble?

Market sages are warning that China will be the next bubble to pop. One can only look at a chart of the ascent of the Chinese market and find similarities when comparing it to the NASDAQ market in 1999 & 2000. We all know how the NASDAQ bubble ended. Along with the fundamental truths of the NASDAQ stocks in 1999 – 2000 how technology was going to change the world (which it has), we hear the same “potential” stories about Chinese stocks and the emerging dragon economy of China and east Asia. However, mixed in this “dragon cocktail” of fundamental positives (emerging economy, companies going public) are two negative factors. The first factor is the momentum players who jump on the “mo” train and are happy to ride until the wind gives out. The second negative factor is investors’ use of margin when investing in this sector.

Margin is the smoking weapon lying next to all the dead bodies. Excess margin brought down the market in 1929. Margin and extreme valuations brought down the NASDAQ starting in spring of 2000. Margin and off balance sheet borrowing brought Enron to its knees and eventually bankruptcy. Our sense is that margin is one of the fuels being thrown into the fire of this smoking market.

Our advice to investors is as follows: If you have exposure to China and the remaining emerging markets, maintain and cut back your allocations as they grow. If you have a 5% allocation to China and it grows to 10%, take some of your winnings and rebalance your position back down to 5% at some point. If you are using margin to leverage your exposure, ask yourself how much of a loss you can tolerate. If you do not have an allocation to China and would like one, it is not too late. We would recommend a 5% maximum allocation using either mutual funds or ETFs. Our recommended funds include: U.S. Global Investors China Reg Opp (USCOX), Eaton Vance Greater China Growth (EVCGX), and Fidelity China Region (FHKCX). The ETFs we would consider are: iShares FTSE/Xinhua China 25 Index (FXI), PowerShares Gldn Dragon Halter USX China (PGJ), and WisdomTree Pacific ex-Japan Total Dividend Index (DND).

You should expect there to be those “Kool-Aid-drinking” investors who will be mad at the naysayers and at the same time, there will be those giving cautious comments just like they were about Greenspan and his irrational exuberance speech in the late 1990’s. The fact remains there is nothing wrong with having an allocation to China and emerging markets just like there was no problem with having a similar allocation to the NASDAQ in the late 1990’s. The question in every investor’s mind should be: 1) how much am I willing to lose; and, 2) at what point or circumstance would I sell this position. If this determination is made up front, an investor will be successful in his investing and traverse the crash when it happens. In the rodeo world, everyone enjoys watching the bull buck. But, few can stay on this bull when the downside crash begins.

Sam Ung

October 25, 2007 11:43 PM

As Chi mentioned, the Chinese Government will support the market until after the Beijing Olympic is over. As such any partial governmet stock will go up up and up!

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Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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