Wednesday, October 24, 2012

Why a “Blindside” by China Means a Great Buying Opportunity

There’s not a day goes by that I don’t see some variation on the theme that China is going to crash, or that somehow that nation will blindside us and that its markets might fall 60%.

This is like saying in March 2009 that the U.S. markets were in for a hard landing — after they had already fallen over 50%. Folks who acted on this argument and bailed not only sold out at the worst possible moment, they then added agony to injury by sitting on the sidelines as the markets soared 95.68% higher over the next two years.

People forget that the U.S. stock market — as measured by the Dow Jones Industrial Average using weekly data — fell more than 89% from 1929 to 1932, more than 52% from 1937 to 1942 and more recently experienced a decline of more than 53% from 2008 to 2009 — and that doesn’t even account for four 40+% declines beginning in 1901, 1906, 1916 and 1973.

Each was a great buying opportunity, and following those meltdowns, U.S. markets rose more than 371% from 1929 to 1932, more than 222% from 1949 to 1956, more than 128% from 1937 to 1942, and more than 95.68% in just over the two years starting in March 2009 — one of the fastest “melt-ups” in market history.

People forget that world markets dropped 40% to 80% in 1987. And as legendary investor Jim Rogers noted earlier this month, that was not the end of the secular bull market in stocks, either.

People forget that our nation endured two world wars, a depression, multiple recessions, presidential assassinations, the near-complete failure of our food belt, plus the deadliest terrorist attacks the world has ever seen — just to name a few.

And guess what? The U.S. has still been the best place to invest for the last 100 years.

So what if China backs off or slows down?

The Asian currency markets blew up in 1997. Mexico’s market passed out during the great tequila crisis of 1994. And Argentina failed to the tune of a 76.9% crash starting in 1997, only to give way to a 1,724.56% rally from 2001 to 2011.

Let’s see…gold rose by over 600% in the 1970s, then fell by 50%, which terrified investors at the time. It subsequently rose by more than 850% — something else Rogers noted in recent interviews, as have I.

China is undoubtedly going to have several hard landings in our lifetime. Despite the fact that China is thousands of years old, modern China is a mere 40 years old — if you consider its birth to be the nation’s opening following the historic Nixon-Kissinger visit in 1972.

And today’s China has 1.3 billion people — all of whom want to live the way you do.

The country is growing by an average of 9% a year or more and has done so every year for the last 41 years straight. Meanwhile, Washington has just poured an estimated $7.7 trillion into our economy and the best we can do is 2.5%. The EU is on track for 0.2% growth in 2012 after trillions in euro backing there.

Make no mistake: China’s government is well aware that it has a problem. Unlike our own government and those in the EU, Beijing raised bank-reserve requirements repeatedly before loosening them a bit last month. It hiked interest rates six times in the last two years.

Beijing is deliberately tapping on the brakes. China’s government actually wants segments of its economy to fail so they can reboot parts of the system, including the real estate market, which is a prime example of this.


The Reality of Real Estate

Real estate has been bid up to obscene levels in many parts of the country — not the entire country, but in parts. And those are the places where Beijing wants real estate developers to fail so values can come back to more realistic levels while capital gets freed up for additional investment.

Take the city of Beijing, for example. There are plenty of writers at the moment who love to point out that it will take the average Beijing resident 36 years to pay for their house, versus 18 years in Singapore, 12 in New York, and 5 in Frankfurt.

Well, to retort, Beijing is a first-tier metropolis, which makes this number an apples-to-oranges comparison. Factor in second- and third-tier cities outside Beijing, Shanghai, Shenzhen and Guanzhou and prices drop to 3,000 to 5,000 RMB/m2 and take 5 to 10 years to pay back, which is roughly in line with international standards.

Look at cities like Moscow, Zurich or Tokyo and the argument falls apart further.

For example, in Tokyo and other cities across Japan, Japanese banks at one point offered 100-year mortgages. And property, once acquired, tends to stay in the family for generations. You can still get 50-year mortgages if you want — and you might need to because property values remain unthinkably high even after a 30-year collapse.

Here are some other things to think about:

  • The U.S. property bubble was nearly nationwide. But Chinese borrowers must put 30% down for first-time purchases, 50% down on second purchases, and make full cash payments for third properties (where third properties are allowed). This means Chinese homeowners and banks can withstand a 30% to 50% drawdown in prices before actually experiencing negative equity, which stands in stark contrast to the U.S., which is riding Occam’s Razor in that regard.
  • Using Beijing as an example for the entire Chinese housing market is shortsighted. While prices in second- and third-tier cities have also experienced increases in value, the runups are far less (relatively) than in first-tier cities. And it is in second- and third-tier cities that the majority of Chinese citizens live. Using Beijing (or Shanghai) as a gauge for the entire Chinese real estate market would be like using Las Vegas, Miami, or Phoenix as a gauge of the entire U.S. property market in 2007.
  • Chinese banks have not collateralized their mortgages into risky collateralized debt obligations (CDOs) and then insured them with unregulated credit default swaps (CDS).
  • Lastly, when the U.S. property bubble burst, our country had more than $12 trillion in debt. China, by contrast, is sitting on $3.2 trillion in reserves (which represents 54.5% of the country’s entire GDP). While Beijing would obviously rather not, it could theoretically recapitalize its entire banking sector and have plenty of money to spare.
  • More Than Manufacturing

    Another doomsday scenario people like to bandy about is the notion that China will collapse if exports fail or U.S. demand drops. That’s a gross exaggeration, and much of the pablum you hear is wrong.

    For example, it’s commonly cited that exports make up approximately 40% or more of China’s GDP. In reality, the figure is 10% to 20% even after decades of explosive growth. The CIA estimate is 18%, and of those exports, the U.S. accounts for a mere 18% of the total.

    Fully 75% of the GDP comes from domestic spending and domestic investment.

    As for U.S. demand, what China-bashers don’t realize is that the U.S. is dangerously close to being completely irrelevant to the Chinese growth model. China will not live and die by U.S. demand.

    There is always going to be an imbalance between the value-added content of what China imports and what the country exports. China’s exports are becoming more and more upscale, just as Japan’s did, which is probably the same pattern for all developing nations.

    This is sort of like the great days of the British Empire — you sell us iron ore and we sell you nails, hammers and shovels. If the value of an economy goes up, it’s only natural that the value of the products it deals with, sells and consumes will go up, too.

    Also, China’s trade surplus is shrinking as a percentage of gross domestic product (GDP), from almost 11% in 2007 to 3% to 4% in 2010 to 0.246% ($14.5 billion) of its $5.87 trillion GDP as of November 2011 — further reinforcing the argument that domestic consumption is becoming a bigger force in China’s economy even with the slowdown.

    Don’t Miss Out

    I’m not saying China is going to have smooth sailing. Then again, neither did the U.S. in the 20th century, and the Dow gained 24,000% over that 100-year period. China is merely going through the first uncomfortable growing pains of its adolescence.

    Remember, in 1912, the U.S. still used child labor, had massive inequalities of wealth, and women still couldn’t vote. So holding China to the same standards as the modern�U.S. is inappropriate considering the country has only been open to the rest of the world for 40 years.

    Additionally, other parts of the Chinese economy are doing very well. Agriculture, most manufacturing, pollution treatment, water treatment, power and resource development are just a few of the areas enjoying tremendous growth.

    The point is, many people look down on China with the same sort of derision once reserved for postwar Japan. And if you grew up in the 1950s or ’60s and thought Japan was only good for cheap toys and didn’t invest there, you missed out in the same way investors who look down their noses at China will eventually miss out.

    Keep in mind that China’s economy is roughly one-third the size of the overall U.S. economy and growing fast. Together, America and the EU are approximately 10 times the size of China.

    So if China does suffer a major correction, it’s not the end of the world — nor the financial markets. And if the markets fall by 60% next year, as some people suggest, I know what I’ll be doing: buying.

    Four Ways to Safely Invest in China

    In the meantime, it’s best to look at China within the overall scheme of things. Here are the investments you might want to consider:

  • Buy yuan. It’s still a blocked currency, but you can legally get your hands on it by using bank deposits, CDs or ETFs. The official story is that it’s being held down. Shenanigans! Since 2005 it’s already risen by 23.29%, which is more than the U.S. government wants you to believe. If anything, the dollar is worth too much.
  • Buy commodities. When China’s markets grow, so too does global demand for raw materials. The nation has no choice but to buy because it doesn’t have many native resources.
  • Buy shares in Chinese companies on Chinese exchanges. One of the things people miss in their rush to dismiss China is that they’re tracking those shares of Chinese companies listed in the U.S. That’s a mistake. If the U.S. markets take a header, of course Chinese-listed companies on the NYSE and other U.S. exchanges will, too. Still, it’s probably best to wait for the dust to settle before wading in.
  • If you’re aggressive, you can even try a classic “short,” then go reverse long once the markets gain their footing.
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