Marketwatch: Andy Xie on the China Bubble

Andy Xie, the former Morgan Stanley economist, has been one of the most vocal articulators of the case for a China bubble. Here’s a summary of his comments from two interviews. The first was released on February 6, 2010, with Bloomberg’s Haslinda Amin:

- Andy expects China’s economy to be okay this year because liquidity is still plentiful. On the one hand, there’s a boom, especially on the property side. On the other, poor employment in the US is likely to limit China because the export sector is so large. Nevertheless, the domestic side is overheating, and China needs to tighten or the bubble can get out of hand.

- The US Treasury yield will have to rise because the appetite for US Treasuries is not as strong as it was before. There’s a price for everything, you just need higher yields to buy the same amount or more.

- the China situation is very related to the property sector and government spending. If banks continue to lend, then the situation can get out of hand. If the banks stop lending, then many projects will be put on hold. So the situation is very delicate. You don’t want to cut back funding quickly. Currently, the loan growth rate is 17%, which is about a “7 trend”, compared to a “10 trend” last year (it’s not clear to me what he means by “7 trend” vs. a “10 trend”). So the government has cut back on lending, but it’s not a significant cutback.

- China has not yet increased interest rates, but the market is now expecting it, perhaps a 2-3% increase. But it won’t be dramatic, and it may not be enough. Before the market didn’t expect monetary tightening, which is why it reacted so sharply to credit tightening (i.e., the increase in reserve requirements and the pullback in lending).

- The data on China property is difficult to ascertain, but property sales are 14% of GDP, which is an unprecedented level. Rental yields are 2-4%, and the vacancy rate is very high, in fact “humongous”. Prices might be as much as 100% overvalued.

- China’s property bubble is in new properties, not existing. In China, the local government is the seller, it’s really a fund-raising operation for them. About half of local government revenue comes from the property sector. In a sense there is a struggle between central and local governments. The fiscal situation is very dependent on property sector.

- The government is taking steps, such as limiting mortgages on 2^nd and 3^rd flats. Demand is very speculative, so it’s very difficult for demand to continue without bank lending. Developers who are paying record prices for land may get trapped. In the last 7 years, land prices are up over 10x, and in some cities it’s up over 20x. The bubble is about to burst.

- The resource trend is more land lasting than others. China has a resource shortage and has huge reserves, a significant amount of money will be put into resources. This is the only story that Andy has faith in. The resource story will continue for several years.

These notes are from another Bloomberg interview on 2/12/10:

- China has again increased reserve requirements, but this isn’t enough to stop inflation.

- China will have to stop inflation, rental ratio is under 3%, the price income ratio in major cities is 20x or higher. They’re hoping for a softer landing but Andy Xie is skeptical

- Interest rates are too low – demand deposit rate is 0%, long term deposit rates are 3%, economy is growing at 8-10% and inflation was reported as 2% in January. Andy Xie considers this not reliable. Plus, saving incentives have gone down.

- With excess liquidity, these moves to increase reserve requirements are not enough. The government actions are only reducing excess liquidity, not turning it around. The loan deposit ratio is 67%, and the deposit reserve ratio is less than 17%. This is not enough to turn around the excess liquidity.

- Also, there is hot money going to China, which will continue. China will have to raise interest rates to show that they’re serious about tightening.

All material presented herein is believed to be accurate but I cannot attest to its accuracy. The writings represent the opinions of the author, and all readers are urged check with their investment counselors before making any investment decisions. This information is for educational purposes only and do not constitute investment advice. There is no certainty that any of the information, charts or graphs presented here would result in profits. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.

Stock Gurus: Robert Prechter

Written Wednesday, January 27, 2010

Robert Prechter, President of Elliot Wave International, is known for the Elliot Wave Theory, as well as for predicting the 1987 stock market meltdown. He appeared on CNBC on Wednesday, January 27, to issue a new warning: that we were headed into the next bear phase. I always like to listen to the “Gurus” and see how they assess the market, what indicators they look at, etc.

Back in late February, early March 2009, as few as 2% of traders were bullish. At that point, Mr. Prechter believes that the market is coming out of something, and it’s time to look to the upside. They had an upside target of 10,000 on the Down, and that was exceeded.

Today, they’re seeing a lot of signals that are similar to the ones they saw at the top in 2007, as well as in the earlier top in 1999 and 2000. He’s quoted as saying, “this is the last chance to get out of the Dow in quintuple digits”. He characterizes the tops as follows:

- extreme optimism; advisors 3x bulls over bears, biggest ratio since 1987
- extreme valuation, dividend yields as low as 2.8% for Dow
- PE ratio is higher than it’s ever been in last few quarters; even if you adjust for future earnings, still expensive
- downside momentum loss in November, December and January

By the way, he published the second edition of Conquer the Crash in December, to give people time to get out.

Not interested in commodities, that run has already occurred. Expects repeat of 2008, when real estate, stock market and commodities went down together, and safest place is in the dollar. Dollar bottomed in November, has stealth rally and they remain positioned in the dollar.

Mr. Prechter is looking for another wave, so he’s being safe. They’re staying in cash and cash equivalents.

How much weight to put on Mr. Prechter’s comments? I did a little more research to get more information on Mr. Prechter’s point of view. It turns out, he’s quite extreme. He believes that US stocks will fall below their 12-year lows hit in March 2009 and that the S&P will fall below 666. He sees bonds falling to lower levels than the panic of 2008, and gold falling 40% off it’s peak value, especially if deflation sets in.

If you look back, he did call the crash of 2008 and that he did call the bottom in late February 2009, telling traders to exit their shorts when the S&P was near the 770 level. But you’ll also find that Mr. Prechter is a perma-bear. He called for traders to be 200% short in November 2009. He also was very bearish in August 2009, although at that time he admitted that just the reliable part had past, and that he could not time the turn. But the last time he called for traders to be long stocks before 2009 was in 1997, and so he’s missed lots of good stuff. According to the Hulbert Financial Digest, his newsletter is in last among all market timing strategies.

Still, he does have some interested points to consider. Here’s a comparison of the 1987 market and the market on October 19, 2007 from an interview on Bloomberg (available on YouTube):

Markets: 1987 vs. October 19, 2007 - 1987 vs. 2007

DJIA Annual Dividend Yield - 2.6% vs. 2.0%

Price of $1 Dividend - $39 vs. $50

Duration Dividend < in 1929 - 3 mos. vs. 13 years

Price/Book Value - 1.73 vs. 4.04

Advisors Net Bullish (>97%) - 156 weeks vs. 468 weeks

Daily Sentiment - % Bulls vs. Bears - 3x > 90% vs. 51x > 50% in last 13 mos.

The dividend yield measure is interesting, because I think that is a valid indication of a bullish market. Still, one thing to consider today is that a lot of companies eliminated the dividend following the 2008 crash. You could argue the measure is still valid despite that fact.

The third item measures how long it has been since dividend has been less than it was in 1929. The argument is that when people don't want dividends, they think they’ll make it up in capital gains.

“Advisors” refers to newsletter advisors.

You’ll notice though, it’s very hard to use this to time the market – the bullish readings in 2007 lasted a very long time. Mr. Prechter was bearish for the two years leading into the 2007-2008 crash. In this interview on October 19, 2007, he cited the fall in commercial paper and the decline in Asian buying of US Treasuries as the indicators of cracks in the stock market.

In sum, it’s interesting to look at some of his indicators, but it’s hard to make bets based on his perspective. As always, he’s one of many points of view to consider.

Marketwatch: A January 2010 Mini-Greek Odyssey

In January, a troika of worries knocked down the market: credit tightening in China; regulation in Washington; and sovereign debt problems in Europe, and particularly in Greece.

Over the last month, we’ve had a litany of explanations and opinions. As usual, the challenge is to make sense of the mess of “answers” that come at you everyday in the media:

- the long-term view – Greece is a small percentage of European GDP – about 2.5%. It won’t go under, they’ll fix it, all the market hoopla is just noise. Use the dips as an opportunity to buy. Many long-term fundamentalist and value players are in this camp.

- the contagion view – where there’s one cockroach, there’s more. Greece is just the first in many, Portugal, Ireland, Iceland and Spain are next (the PIIGS countries). Credit default swaps (CDS) prices are exploding (this is the cost of insurance on debt), this is just like Lehman Brothers in 2008. Get out of the market and stay out. Many traders are in this camp.

- the macro bull – this point of view says, we’ve been up huge in 2009. It’s about time for a correction. We’ll correct 10-15%, and then we’ll resume our upward path toward recovery. Ride it out, we’ll be up by the end of the year.

- the macro bear – this view says that it’s just the beginning of the second half of a double dip. Stimulus is being withdrawn around the world, and we’ve got nothing but problems ahead of us: more real estate losses; consumer is dead in the water; productivity is up but demand is not; unemployment remains high. Sell and put your money in cash or short term bonds.

These perspectives are all over the map. Is there a right answer? Is there a best course of action? If there is, it’s not clear by any means. And truth is, several o f these views are correct – depending on what your time frame and your risk tolerance is.

Let’s start with the hold approach. Truth is, this will all blow over – eventually. But that “eventually” could be a long time from now, and in the meantime, your stocks could be down 10-15% from where they were in January. As of today, the S&P is down 5.2% year-to-date (the S&P was 1,115.10 on 12/31/09; today it’s at 1,070.52) and 6.9% off the year-to-date high of 1,150.23 recorded on Tuesday, January 19, 2010. Being down can be no fun; handling it takes a strong stomach and lots of patience.

For me, the other problem with the hold approach is that it’s a bit simplistic and could lead you to ignore several fundamental changes in the market. Last year, a weak dollar led to a strong dollar, a rally in commodities and rising gold. This pattern, which governed trading in 2009, no longer applies. Now, we have a different set of relationships in market:

- With problems in the Eurozone, capital is moving into dollars for safety. This causes the dollar to rise and the Euro to fall. If you think about it, there’s really no where else to go; Asian, Latin American and Russian currencies are all worse choices.

- The rising dollar means lower commodities prices, because commodities are traded in dollars. This explains the fall in commodities investments, and implies that you should stay out of commodities as long as the dollar is rising.

- The rising dollar also means an unwind of the carry trade. Because the US has near zero interest rates, money was borrowed in US Dollars and financed investments around the world. As the dollar rises, borrowing becomes more expensive because borrowers have to convert back to dollars to repay their debt. A rising dollar forces the borrowers in the “carry trade” to sell off their stocks and repay their US Dollar obligations before their debt becomes more expensive. For now, the rising dollar puts selling pressure on stocks.

- Finally, the rising dollar causes the price of gold to fall. Gold is intricately linked to currency movements and rises in two scenarios: when major such as the US Dollar are low and declining, because gold becomes a greater store of value than the currency; and when there’s inflation, because again, gold becomes a better store of value. So as the dollar rises, it becomes a better store of value relative to gold, causing gold prices to fall.

As you can see, these are major trend reversals, and has significant implications for investing. These relationships affect a number of stocks, so it’s not at all clear that you should hold on to all stocks as these relationships shift.

The sell approach has its advantages and challenges. First, if I can spot the decline, I’d like to avoid as much of the 5-7% decline in the market as much as possible. And keep in mind, some sectors are already in correction range, well in excess of a 10% decline. So if you hold such sectors (commodities, financials), selling would definitely save some red ink. If I can’t spot it, it’s not terrible, but it does mean looking at significant pullbacks in your positions for a while.

The next challenge is, when to buy? And should the money be re-allocated into different investments?

Unfortunately, we are likely to face a choppy period, governed primarily by a downward trend. Consider the European sovereign debt situation. Today, the market rallied because it seemed likely that some kind of bailout for Greece was forthcoming. If so, we will rally. Still, it will not be long before investors start to pressure the other European weak links – Portugal, Iceland, Ireland and Spain. So we’ll have more market retreats sparked by European debt fears. Meanwhile, the Euro should continue to decline, and the dollar should continue to rise. Because this will continue for some time, there is no clear “re-entry” point for buying stocks. There’s no clear case for saying that current market levels will hold; any one of these alarms could send markets below today’s levels.

As for the re-allocation question, this is a key consideration. The relationships described above imply the following:

- commodities will remain under pressure, especially if more bad news comes out of China (such as further credit tightening)

- gold will be limited by the rising dollar

- long dollar, short Euro – this is basically the trend for both currencies so long as Eurozone problems are at the forefront

- equities as a whole will remain pressured by the continued unwind of the carry trade. At some point, traders will find another source of funding, but that will take some time

- financials tend to be pressured by sovereign debt fears; as long as these continue, financials will be under pressure

- cyclicals should also be pressured as economies around the world retreat. It’s now a fair question whether 2010 earnings targets will be achieved.

- long short-term Treasuries in the near-term. When fear grips the markets, investors want dollars and US Treasuries. The short end of the yield curve is the favored place to put money in times of stress. The longer end of the yield curve is problematic because European debt now sells for higher yields, and will have a bit of a spillover effect for all. Also, all countries are withdrawing stimulus and tightening credit, which will cause the longer end of the yield curve to rise.

ETF Watch: PGF

I inherited a portfolio that contained the PGF. At first blush, the PGF looks great: it has a 9% yield. Pundits like Cramer love it. But let’s get serious and do some homework.

The ETF. So if you look up the PGF (http://www.invescopowershares.com/products/overview.aspx?ticker=PGF), it's the PowerShares Financial Preferred Portfolio. It’s a fund based on Wachovia’s Hybrid & Preferred Securities Financial Index (WHPS Financial Index). You can’t invest in an index, so the PGF seeks to track the WHPS Index. The fund will invest at least 90% of its total assets in securities that are in the base index.

Fund Holdings. So the first obvious question is, what’s in this thing? When you go to the product homepage (above), there’s a little link that says “Fund Holdings”. That takes you to this page: http://www.invescopowershares.com/products/holdings.aspx?ticker=PGF. You’ll see that as of 1/12/2010, there were 39 holdings and the top holdings were Bank of America, Barclays, ING, Wells Fargo and JP Morgan Chase preferreds. Looking over the list, there’s a few banks whose financial condition I’m not familiar with, such as AEGON, ING and REPSOL; and many banks that I’m comfortable with, such as BAC, Barclays, Wells Fargo, JP morgan, HSBC, Credit Suisse, Goldman Sachs, Santander and Prudential. There’s a couple holdings whose stock I wouldn’t buy – Royal Bank of Scotland and National Bank of Greece.

Overall, I’m fine with the holdings because I believe that the worst of the financial crisis is over. There could still be problems this year, particularly this summer. But in the long-term, we’re on an uptrend in financials. While I wouldn’t buy Royal Bank of Scotland and National Bank of Greece, I don’t think they’re going under.

Fund Yield, Price and Expenses. Other key facts include a 30-day yield of 7.59% and a 12-month yield of 8.39%. It trades at $17.12 and has an expense ratio of 0.68%, a bit high but much lower than a mutual fund.

Risks. So let’s look at the risks and downsides. First, let’s start with the equity risk. The PGF is comprised of financials (as the name implies). Critics say that you would be getting a 8-9% yield but would be risking a 100% loss. Still, as mentioned, I believe the worst of the financial crisis is over. We may still have a dip in the medium-term, but in the longer-term, we’re on an uptrend as the recovery continues. In my opinion, the biggest risk is a dip in the medium-term as latent financial problems (e.g., foreclosures) surface.

Later, banks could also take a hit when the yield curve flattens. Longer-term rates will rise. Because banks borrow short and lend long, this will, at first, help banks. But eventually the Fed will raise short-term rates, causing the yield curve to flatten. This will lead to lower margins for banks. This is something to watch out for, particularly toward the end of the year

Second, let’s look at the preferred security itself. Preferred stock has a fixed dividend, and that makes it vulnerable to interest rates. So when interest rates rise, new securities are a better investment because they offer a higher rate of return than existing preferred. This would imply that the price of the preferred stock would fall. On the other hand, banks perform better with a steeper yield curve, and that could increase the value of the preferreds. So the impact on the PGF itself is unclear. More than likely, the PGF will have to sell off declining securities and reinvest in newer securities, leading to some losses in the fund. Truth be told, all this is theoretical at this point. We will have to see what happens when rates rise, be vigilant and be prepared to exit if the value drops significantly.

Eventually, the yield on preferred stock will drop. An 8.5% to 9.0% yield is a reflection of our times, when financial stocks are worth less than they are in “normal” times with normalized earnings. Another factor to watch out for in the longer term.

Other Considerations. So here are some other pluses and minuses of preferred stocks:

- Preferred shares are higher in the capital structure than common stock

- Dividends must be paid to preferred stock owners before being paid to common stock holders

- Dividends are fixed

- Preferred stock holders have no voting rights

- Because preferred shares have debt characteristics (fixed dividend, like a bond), they also have less potential for share price appreciation

- Many preferred shares dividends are qualified dividends taxed at 15%, unlike bond income, which is taxed at regular rates. The tax treatment of dividends may change the coming years.

Managing the Investment. Tom Lydon, an ETF guru and author of the ETF trend Playbook, has three rules for managing ETF investments:

- maintain an 8% stop loss on ETFs

- if the ETF falls below the 50-day moving average, that’s a red flag. If it falls below the 200-day moving average, then sell

- don’t chase markets that are too hot, such as in 2000.

He also says that you should only invest in ETFs trading above their 200-day moving averages. If you look at a chart of the S&P since 1994, it was best to stay out of the market when the S&P traded below it’s 200-day moving average.

Here’s an example of applying one of his guidelines. If you buy an ETF trading 15% above its 200-day moving average, then you should have an 8% stop loss.

Interestingly enough, these guidelines could apply to more than just ETFs. Not a bad set of guidelines to work with.

Other ETFs. So the PGF isn’t the only preferred game in town. There’s the iShares S&P U.S. Preferred Stock Index (PFF), created in March 2007. As the name implies, this tracks the S&P U.S. Preferred Stock Index. It invests at least 90% of assets in securities that comprise the index, which includes stocks listed on the NYSE, AMEX or NASDAQ. Companies have a market cap of at least $100 million and the fund is non-diversified. The PFF’s expense ratio is 0.48%, a low turnover of 12% and the yield is about 8.58%. Currently, it trades at $37.63.

There’s also the PowerShares Preferred (PGX), which seeks to track the Merrill Lynch Fixed Rate Preferred Securities Index, established in January 2008. At least 80% of total assets are invested in the Merrill Lynch Preferred Index. The expense ratio is 0.5%, it has a high turnover of 52% and its current yield is 8.09%. As of today, it trades at $13.68.

Conclusion. Generally, I like the preferred stock ETFs at this point in time. There’s some risk that prices may fall after this point, but eventually, in the longer-term, prices should rise as we get closer to normalized earnings. At that point, yields will fall, so it will have to be re-evaluated as an investment. In the meantime, I will be holding on to the PGF in the portfolio I’m managing. And of course, watching out for the risks outlined above.

Stock Gurus: Bill Miller

Legendary stock guru Bill Miller appeared on CNBC today. He manages a Legg Mason fund, and holds the record for beating the S&P (15 years), until the crash of 2008, that is. His portfolio has since rebounded as much as 40-80% (depending on what you’re looking at).

Mr. Miller is just behind Warren Buffet in the world of value investing. I respect his opinion, but like everything else, I think you have to keep things in perspective. For example, if you’re down 70% one year, and then up 100% the next year, you’re still down 35%. So don’t let these percentages fool you.

Also, you have to keep in mind that value players favor looking at valuation, which creates a bias. In Mr. Miller’s case, he may tend to underestimate the macro picture. I’ll give two examples. The first is real estate. Mr. Miller is long real estate and argued for a recovery. He’s down on that investment – he joked about being “early”. But oddly, no one on the desk of reporters (which is why I think it’s such a shame that reporters are asking questions) asked what happens when interest rates go up. Real estate will go down again, I believe, and how much depends on how much inflation there is. If that’s true, it means that he’s very early on real estate, the cycle isn’t over. On the same day, Professor Shiller of the well-known Case-Shiller Index admitted that there’s better than a 50% chance that real estate prices will go down again.

The other example lies in the 2008 crash. Mr. Miller didn’t see it coming, and that’s because he was looking more at valuation (price-to-book, PE, etc.) than at macro trends (in my opinion, he didn’t say that). In this interview, admitted that they’ve learned a lot. Before, he would have said that the depression scenario was off the table. Now, he has a different view: there are two different kinds of downturns – liquidity , as in 1987, when the Fed pumping money into the system was enough; and asset or balance-sheet downturns, where the value of assets decline and this is what the Great Depression was. This actually makes lots of sense. Consider the post dot.com period, when savings went down, but employment held up relative to 2008; and individual’s assets – such as real estate actually gained. In 2008, both savings and assets took a hit. So that’s a good way to look at it, I think.

Mr. Miller does think that there are still great values in the market, and of course, that’s the interesting part. He believes that the worst is over, but the recovery is far from complete. And the risk after a major event such as the 2008 crash is relatively low.

Mr. Miller’s example was IBM, which trades at 12x this year’s (2010) earnings. The company has top line growth of close to GDP levels, so not much exciting there. It’s the bottom line that’s interesting – it produces cash, so IBM buys back stock and earnings go up. It has performed consistently, even in this down market. I agree, lots to like there, especially for retirement portfolios.

Other picks include regional banks, that are trading at discounts to book value with good capital ratios; GE, Walmart, JP Morgan (with earning’s power of $6 or so, implying a $60 stock at 10x PE); Bank of America (with earning’s power of $3.50, implying $35 stock at 10x PE); JNJ, Pfizer; Merck and MGIC (which provides mortgage insurance, trades at about half of what it’s worth, and will someday make money in mortgages again).

I am long General Electric, JP Morgan and Bank of America.

January Stock Article

Here's my January investing article at www.asiancemagazine.com:

http://www.asiancemagazine.com/2010/01/03/investing--the-shifting-landscape-

Stock Gurus: Doug Kass on Calculating the Bottom

Doug Kass appeared on Fast Money on 10/28/09 and discussed how he calculated the bottom this last March.

- Looked over 7 decades of S&P data. Market is valued at about 15x usually, 11.5x at the bottom.

- Book value of the S&P = $560 at the time. The average industrial earns 12%, or $67.

- $67 x 11.5 = 770, or about 800 on the S&P

- On March 9, 2009, S&P was at 685, way below. 685 is 9.7x (actually, 10.2x if you do the math)

- PE was also very low, especially in a time of quantitative easing.

And thus he called bottom in March.