The first trading day after the Asia-wide three-day holiday, and following the weekend announcements of Lehman Brothers Chapter 11 filing and the buyout of Merrill Lynch, China’s stock markets dropped in tandem with Asian and world markets.

China Supertrends has been following the financial implications of the sub-prime crisis for a while now and will comment on this latest development and the state of China’s stock markets in a separate post. Today, Tuesday, September 16, was yet another blood-bath in the markets, but at a time like this it is worth remembering that China’s underlying economic fundamentals remain very strong.

In fact, China just came off yet another strong month of growth. If this is true, what causes the apparent contradiction of one of the world’s best performing economies having one of the worst-performing stock markets?

In brief answer to this complex question, let’s just say that the theory of decoupling - the idea that China and other developing countries are mature enough to continue to develop on their own during an economic decline in the US and elsewhere - is increasingly discredited.  We wrote as much in Supertrends: We are living in an inter-connected world, and nothing, not even neo-Mercantilist policies, a protected currency, nor the world’s largest foreign reserves, can resist the forces that are sweeping our world.  As John Donne famously said, no man is an island. This financial crisis calls to all governments to act.

China, with its strong economic performance in August and year-to-date, may appear to be in the eye of the storm, an island of calm and prosperity. Last week was the Mid-Autumn Festival, and the economists at China’s National Bureau of Statistics were producing new data faster than mooncakes at Wang Jia Sha. Virtually everything seems according to plan.

Starting with the drivers of the economy, consumption continued to show signs of strength, with retail sales maintaining a 23.2 percent pace of growth in August, only slightly lower than July’s 23.3 percent, the fastest rate since 1996, according to the Shanghai Daily.

The level of retail sales growth is far above the most recent inflation levels, meaning retail sales growth is not just about price increases, there is real growth there.  In fact, CPI - the consumer price index, or basic inflation - decreased to 4.9 percent in August, continuing the downward trend, but worrisome PPI - the prices producers are paying for raw materials and commodities - continued to climb, to 10.1 percent in August. PPI increases will, at some point, either result in decreased margins and profits as companies absorb the increases, or get passed on to consumers as price increases, so China is not out of inflationary woods yet.

Many were regarding the fight on inflation to be one of China’s core economic policies of 2008, but in a surprise move today the People’s Bank of China decided to cut interest rates by about a quarter percent, down from 7.47 percent to 7.2 percent and, in perhaps the most surprising move of all, cut the reserve ratio by a full one percent after having just increased it by one percent in June.  Now that the Olympics are over, micromanagement of the economy seems back in style.

But the message, that the economy is ready for a rate cut and wants to increase money supply, could be evidence that the PBOC overshot the mark and caused money supply to shrink too quickly, contributing to some of the summer’s abysmal stock and real estate performance.  Growth in M2, the money supply, decreased to 16 percent in August, down from 17.4 percent in June.  It is important to point out here that we are still talking about an increase of 16 percent, just that the rate of speed it was growing simply slowed down a little.

Is the PBOC acting wisely or foolishly? Time will tell if they are cutting too soon, a knee-jerk reaction to the latest sub-prime casualties, trying to prop up the falling stock and property markets, or if they are presciently avoiding a much harder crash in the wake of Fannie/Freddie/Lehman fallout and other factors yet to come.

While some of this data could be construed as negative, China had a lot of other positive economic results in August. For example, the trade surplus is up by 25.7 percent year-to-date, compared with Jan - Aug 2007 figures.

In August, with industrial output growth the lowest in 18 months, a mere 12.8 percent increase, exports decreased to 21.1 percent from 26.9 percent in July. Imports were down more dramatically, from 33.7 to 23.1 percent, mostly because of commodity import price decreases  (i.e. oil), so the trade surplus actually still got bigger. 

Though slowing its rate of increase slightly, clearly China’s export prowess is not affected significantly by the world-wide financial crises, and despite the 2008 increase in  the strength of the RMB exporters seem to have adapted. The sky, it woud seem, is not falling, though its perhaps a paler shade of grey. Ecnomists, analysts, and the Chinese media make a lot of dire proclamations about how the Chinese economy is in decline but this is better thought of as healthier, sustainable growth.

I could go on. FDI and other investments - still strong. Foreign reserve size- still troubling, but thanks to the Fannie Mae / Freddie Mac bailout, the 20 percent of reserves held in US mortgage debt appears safe.

So the question originally posed, why is there a contradiction? China’s strong economy (with all the usual provisos and assumptions about the data, of course) on the one hand, and its weak stock and property markets on the other. What gives?

Is this a sign that global markets cannot decouple and are doomed to falter together, or is it a sign that somebody needs to act more decisively?  Just as China became a stabilizing force in the Asian Financial Crisis of 1997, is there are way it could use its economic and financial strength to do so again?

No country is an island in our globalized world.  Everybody has a stake.  With the alarm bells sounding, can China passively wait for the U.S. to get through its bailouts, and hope that the world financial system remains intact?  Or does this bell ring for another?  Whom does the bell toll for?  China, it tolls for thee.

Who wants to be a multi-trillionaire?

Based on the apparent pace of growth in China’s foreign reserves, the State Administration of Foreign Exchange may need to answer this question in a mere three months. Its answer should be an emphatic “Not China.”

In fact, SAFE’s next quarterly announcement of foreign reserves is not due until July but unconfirmed reports have been flying through state and foreign media (covering an unofficial number in China Business News interestingly) that China’s foreign exchange reserves increased by US$74.5 billion in the month of April alone, to reach US$1.76 trillion.

As a point of comparison, the world’s second largest foreign reserves are held by Japan, and in March 2008 they increased by one tenth of China’s apparent April gains - just US$7.6 billion. Incidentally, it was only in February that Japan’s foreign reserves surpassed one trillion for the first time, and they have since fallen back below the trillion mark, once again leaving China the lone member of the trillionaire’s club.

China first hit the one trillion mark way back in November 2006 but, unlike Japan, its foreign reserve increases are usually measured in double-digit billions. If later confirmed by SAFE, April’s increase of US$74.5 billion will be the biggest ever increase, anywhere.

If this pace continues, China’s foreign reserves could reach two trillion as early as August this year.

This is perhaps not the message China’s government wants to send to the world during the Beijing Olympics (”All your money are belong to us”), so there is intense discussion at the highest levels of China’s government over two issues: How to reduce the foreign exchange reserve, and how to use the existing foreign reserves more efficiently.

Reducing China’s Foreign Exchange Reserves

At one time, having enough money on hand to pay for imports might have been a prime consideration, but this has not been the case in China for years. Its current amount of reserves may cover monthly imports 15 times over, or more. What about another main reason countries keep a large foreign exchange reserve on hand, to defend the currency from speculative attack?

China does not allow convertibility of the yuan, which curtails the possibility of a run on the currency, but as well, China, together with the ASEAN countries plus Korea and Japan (the so-called ASEAN + 3), recently pushed forward the Chiang Mai Initiative, a US$80 billion foreign reserve pool that could be swapped to any member country experiencing speculative pressure. In theory, from 2009 this could reduce the need of Asian countries to hold such large foreign reserves. Until then, Asian central banks may feel better safe than sorry and decide to keep more reserves on hand, but China really doesn’t need to do this in the first place, so it needs to more aggressively reduce the size of its foreign currency holdings.

One way to reduce the size of the foreign reserve is to encourage foreign currency outflow. At present, the yuan’s continued and still expected appreciation has actually increased inflows, both as FDI and as hot money, to record levels.

In the first four months of 2008, FDI was up almost 60 percent over the same period last year, while the total number of company registrations actually decreased by 23 percent, according to the Ministry of Commerce. One likely explanation for this is that foreign firms inflated their average investment size so as to benefit from the future yuan appreciation. In fact, for hedge funds and other investors, this is one of the only methods they have to skirt Beijing’s capital controls, sneaking money in as legitimate-seeming FDI. The exact amount of hot money is unclear but can be inferred from known inflows (e.g. announced FDI), the estimated trade surplus, and other data.

To lessen the inward flow of hot money, China could either reduce interest rates to make passive funds less profitable in China, or could revalue the yuan exchange rate in a one-off revaluation similar to 2005 when the original dollar peg was removed. The former is likely to exacerbate China’s current inflation problem, while the latter would shock the country’s exporters. On balance, allowing the yuan to appreciate faster seems the lesser of two evils for the government.

An appreciation will cause outflows for several reasons. Some of the hot money will repatriate, while the stronger Chinese currency will encourage more consumption and imports from abroad. If the trade balance can reverse the current trend of annual surpluses, foreign reserves will dwindle rapidly.

Using the Foreign Reserves more Effectively

The second issue on China’s leaders’ minds is how to use existing reserves more efficiently. Some may even wonder why large foreign reserves are a problem at all. A rich country is a strong country, as this argument goes.

But the foreign reserves are, in effect, sitting in the central bank earning meager returns and keeping the yuan under-valued. Each unit of foreign currency that enters China is bought up by SAFE and yuan notes are issued by the central bank.

China does not actually hold wads and wads of cash, like a high-roller hitting Macau’s new casinos. Most of its funds, especially those denominated in US dollars, are in the form of US Treasury bills and other long term securities. T-bills have a notoriously low interest rate because they are seen as the safest investment available.

With China holding an estimated US$466 billion in T-bills alone according to the US Treasury, earning interest in the low single digits, this means China is literally leaving billions in potential investment income on the table.

Couple this opportunity cost with the depreciation of the US dollar against major world currencies and China’s US dollar holdings are looking even less attractive. Given a common estimate that China’s total foreign reserves are comprised of about 70 percent dollar-denominated securities and cash, and that the depreciation in the US dollar over the last year has been about 10 percent against the yen and 13.5 against the Euro, that is like saying those Chinese reserves in US dollar terms have lost about US$100- 150 billion in spending power.

Of course, China’s Euro and Yen holdings have increased buying power in terms of US dollars, but they only represent about 20 percent and less than 10 percent respectively of China’s foreign reserves. With such low interest returns and the passive depreciation of its US dollar holdings, China is anxious to look for other ways to spend its growing fortune.

In the last six months, SAFE has made a number of portfolio investments abroad in an attempt to diversify and increase returns, while China created the China Investment Corporation, a US$200 billion sovereign wealth fund, in 2007 to place funds in higher-growth areas. [ED: I covered the uses of China's foreign reserves by both SAFE and CIC in an earlier post, The New Gold Mountain.]

At the time of writing, the yuan appreciation has reached 20% against the dollar since that fateful day in 2005 when the peg was finally removed. It has taken three years to get here, and if it takes three more for the next 20%, I worry about the effect this will have on inflation in China as the foreign reserve will continue to surge.

There’s no easy solution to China’s growing problems of inflation and low rate of return on its reserves, but letting the yuan appreciate more quickly is probably the best place to start, for the sake of the Chinese economy, and maybe even the global economy, as a whole.

[UPDATE: June 25 - Two notes which just came to my attention: In regard to how some foreign media have not covered the April 2008 rise of US$75 billion as alarming or even sufficiently surprising, Yves Smith of Naked Capitalism commented yesterday on the apparent nonchalance, and overnight Brad Setser added some data on changes in China's portfolio investments and overall foreign asset growth. On the point of western media attention: I don't think the lack of in-depth coverage on the ramifications is indicative of disinterest. As I pointed out above, the April foreign reserve figure of US$74.5 billion hasn't been officially confirmed and will not be until July, most likely. I held off reporting on this figure in my newspaper column until June 23 expecting a repudiation by SAFE or the PBOC, but their combined silence on this issue has been deafening.]

Two months ago I discussed in this post the effects of regulation on the stock markets in China. My theory: After the precedent China’s regulators set in April by offering two investor-friendly policies timed to pump up the markets, China’s investors would now get in the habit of looking to the government for a bailout whenever the markets were in trouble.

At the time, I predicted that the existing market fundamentals affecting China (high inflation, decreasing exports, high oil price etc) would eventually re-register with investors, and we might see another dead cat bounce. Well, the cat is back:

The above chart shows China’s CSI 300 Index, the measure of both the Shanghai and Shenzhen stock exchanges.

Two periods to take note of: First, April 20 to 24, when the two regulatory actions were announced, a clear jump in the markets was evident. Overjoyed would be an apt description of investors when their stamp duty was reduced.

Second, May 12 to 19, the week following the Sichuan earthquake, there was market confusion until May 20. Thereafter indexes began their slide over uncertain earnings growth and worries about the 8.5 percent April inflation figure, announced just before the earthquake, started to sink in.

So, what now?

The China Securities Regulatory Commission faces a dilemma: Does it toss the market a bone, perhaps by offering investors margin trading as some are predicting? Or will it finally let modern investors learn a hard lesson in stock market bubbles? As of June 11, the markets are setting new 2008 lows and volumes are dramatically down as investors start waiting for the bailout.

While I am in favor of China’s use of industrial policy to grow the economy, my admiration doesn’t extend to such shallow tactics as propping up the stock markets. Margin trading, suddenly thurst upon the investing public at such an uncertain ecomomic time, would be an unmitigated disaster in my opinion. China’s development needs to be sustainable, so supporting the pusuit of easy money is not one of the solutions China’s leaders should be considering.

Milton Friedman was thought to have said, “The stock market and economy are two different things.” Looking at the recent actions of the China Securities Regulatory Commision and Chinese leadership, the two appear increasingly intertwined. This is setting a dangerous precedent for Chinese government intervention in the stock markets: Last year by increasing the stamp duty to cool the market’s irrational exuberance, this year by goosing it to prevent market losses from spilling over into the general economy.

In the long-term this will inevitably create more instability in the system for several reasons. While some regulation is good - corporate reporting standards, for example - micro-management of the stock markets to cool the economy or appease the public should not be the role of a regulator. Friedman, who implictly blamed government mismanagement for causing the Great Depression, abhored government interference in the markets except for defending against a systemic collapse. If he saw what was going on in China’s stock exchanges, he would be rolling in his grave.

In late April the CSRC announced a pair of regulatory actions designed to stimulate the market after its free-fall in March, which saw Shanghai’s Composite Index decrease by 20 percent, its biggest one month loss ever. The first, a block trading system for sales of more than one percent of outstanding shares, was announced on April 20th. In the next trading days the reponse was lukewarm, the index went up only six percent. Clearly more investor relief was needed and, on April 24th, the Commission delivered a cut to the stamp duty, the tax on transfer of stocks, from 0.3 percent to 0.1 percent. The next day, Shanghai’s index increased by 9.29 percent and, for the week, up 14.96 percent, the biggest one week gain on the index, ever.

Whenever I want to know how the stock markets in China are performing, I can ask several of my Shanghainese friends whose sole occupation is chao gupiao - stir-frying stocks. If they say they’re in a bad mood that day, I know the market is down, if they’re in a good mood, the Shanghai Composite must be up.

Thinking back to March, my friends were in a very bad mood. The Shanghai index had its largest monthly drop in the last ten years, just over 20 percent, and this made for some bubble-popping pessimism. Then in late April, the emergency regulatory moves to stem the bleeding were like a one-two blow to the pessimists: A block-trading system was unveiled to stop quanties of shares from flooding the market, and, most importantly, the stamp duty was reduced from 0.3 RMB per share to 0.1 RMB per share. That day, my stir-frying friends cooked up an extra-large serving, so overjoyed were they. But in a nation with a 5000 year historical memory, didn’t they remember the last time the regulator lowered the stamp tax, then raised it again, then lowered it again, or raised it once again? The public have started to buy and sell based on the actions of the China Securities Regulatory Commission, not on the fundamentals of the stocks themselves.

From the best major-index performer globally in 2006 and 2007 to one of the world’s worst performers in 2008, is there anything wrong with the Shanghai stock market then? According to one local investor, “Too much government interference, that’s what’s wrong with these markets…Things won’t improve until the government leaves these companies alone to get on with their business.” That’s good advice, perhaps from last month when the market was in freefall? No, it quoted in an article from the May 29 1996 International Herald Tribune. Clearly, when it comes to government participation in the markets, old habits die hard.

It occurs to me then that these techniques, for questionable short-term benefit, only serve to further destabilize the fragile market equilibrium by increasing moral hazard. This term, when applied to investing, means taking too much risk in the belief that one will be bailed out if things go wrong. In early April trading volumes were way down: Clearly Chinese investors were expecting the government to do something, waiting for it in fact, to bail them out after the worst trading month on record. Now that the Commission delivered, the expectation will be increased the next time around. Any recovery will be short-term at best, and we are likely to see more Dead Cat Bounces.

As I disucssed in the innaugral post of this blog, the idea of a dead cat bounce is a temporary reprieve from a downward trend, due to some optimistic investors or positive news coming out, but lacking a fundamental change in the factors driving the bear market sentiment.

April 30’s Shanghai Daily reported that 1574 listed firms had combined 2007 profits of more than 136 billion US dollars. Meanwhile, a commonly reported statistic is that 15% of corproate profits, or about 20 billion US dollars, were from stock market speculation in 2007. You may want to reread that sentence if the implications aren’t clear: A major source of profit for Chinese firms, not including invesment banks or insurance companies which have to invest, is buying and selling stocks retail. Nor is this is not some kind of strategic, pre-merger or cross-shareholding action as Japanese companies are apt to do (and lost more than US$3.2 billion on in 2007, incidentally). It is plain speculation.

A year ago, the Commission had to prohibit Chinese firms from using thier IPO funds for speculation on the stock markets, so widespread was the practice of many companies to invest their working capital into stocks, bonds, and derivatives. You might be thinking it is all insurance companies and investment banks when you should be thinking Zhengzhou Yutong Bus Company, one of China’s top makers of buses, investing part of its IPO funds into other companies’ IPOs. It was not alone. The lure of easy money was too great.

In 2007 you may recall that Shanghai’s market was the best performing major index in the world, gaining 97 percent after a 127 percent increase in 2006. This year, with the index dropping sigifantly off its 2007 highs, one might wonder how many companies are sitting on losses right now. Bounce.

The new block-trading system recently announced, whereby amounts of shares over one percent of the total outstanding had to be sold in a block trade, seems like a good way to prevent shares from flooding the market. In the days following the announcement, numerous companies were found to be selling 0.99 percent of their holdings at a time. Bounce.

Of the last four times the stamp duty was modified, the three times it was decreased were in flat or declining markets with no appreciable long-term stimulus, and the one time it was increased, May 2007, the market continued its great bull run. Now tell me again the logic that decreasing the stamp tax will push the market back into bull territory? Bounce.

The big question on Chinese investors’ minds is, how low will it go? I’m reminded of some other stock market investment experience that I wish I could share with Chinese inv estors. This situation in China’s stock markets seems eerily similar to teh Dot-Com NASDAQ bubble around 2000 (the equavalent of 2007 in China) and 2001 (how China’s marketrs are right now). From the classic “Buy the Dips” investment stategy to “Sell the Peaks” all in the course of about a half year. The Shanghai Composite index is close to having lost 50 percet of its value from the 6000+ point high which occured … about six months ago. My bet then is that we have not seen the last of the declines in 2008, though we might see a few dead cat bounces before the end of the year. Meow.

In the mid-19th century, people in China dreaming of wealth may have thought of Gold Mountain, or Gum Shan, the Cantonese name for California. Tens of thousands of Chinese flocked there, seeking their own claim to riches.

Now, in 2008, wealth-seekers don’t need to leave home, the Chinese are actually sitting on the new Gold Mountain - China’s 1.68 trillion dollars in foreign currency reserves held as of the end of March: $1300 for every man, woman, and child. In a country where GDP per capita is still less than $2500 (additional source), that’s no small change.

Yet, in much the same way as the miners of the 1800s were lucky to see a small gold nugget at best, so too does China’s populace sit upon a mountain of gold that is nonetheless maddeningly out of reach. China is not doing enough to control its foreign exchange reserves, and needs a new way to deal with them, and fast, or it is likely to continue to suffer the main ill of having too much money: Inflation.

The Story of Foreign Reserves

A country, especially a developing country such as China, needs foreign reserves. To simplify matters, in order to facilitate trade amongst diverse nations with their own currencies, the world needs a common representation of value. Historically that was gold. Today, gold has been supplanted by several reserve currencies such as the US dollar, Euro, and the Yen, and the value of those currencies is ultimately backed by confidence in the goods and services produced by those countries.

Developing countries, in order to trade, need that foreign currency, and typically have several months of reserves on hand to cover the average cost of imports. Every prudent country needs a few months’ reserves for a rainy day; eight to ten months worth could be considered extremely cautious. China had sixteen months of reserves available to cover its $91 billion in imports in January. The People’s Bank of China on April 11th announced the official size of the reserve at 1.68 trillion dollars as of the end of March 2008. And the country is getting richer faster than ever before, with reserves growing 40% more in March than the same period last year.

A second reason to have reserves is to be able to defend the home country currency from speculative attack in the foreign currency markets. For example, Thailand could have used a few more dollars back in the 1997 Asian Financial Crisis, but China does not allow convertibility of the RMB, which curtails the majority of currency speculation, thus making this point moot.

Finally, reserves are used to cover foreign debt. China’s estimated $363 billion plus of foreign debt at the end of 2007 is nothing to scoff at, but SAFE will not be bouncing any cheques. In fact, China has the largest foreign reserves in the world, nearly double those of number two Japan. So, what gives, China? Why the massive foreign reserves?

China’s Big Piggy Bank

China does not actually hold wads and wads of cash, like a high-roller hitting Macau’s new casinos. Most of its funds, especially those denominated in US dollars, are in the form of US Treasury bills and other long term securities. T-bills have a notoriously low interest rate because they are seen as the safest investment available. With China holding an estimated $466 billion in T-bills alone (full data, 2), earning interest in the low single digits (even hitting a 50-year low at recent auctions), parking so much money in low-yielding securities means China is literally leaving billions in potential investment income on the table.

Couple this opportunity cost with the depreciation of the US dollar against major world currencies and China’s US dollar holdings are looking even less attractive. Given the consensus estimates that China’s total foreign reserves are comprised of about 70% dollar-denominated securities and cash, and that the depreciation in the US dollar over the last year has been about 14% against both the Euro and Yen, those Chinese reserves in US dollars have lost about 100 billion in spending power. Of course, China’s Euro and Yen holdings have increased buying power, but not in proportion as only about 30% are in non-US dollar assets. With such low interest rates and the passive depreciation of its US dollar holdings, China is anxious to look for other ways to spend its growing fortune.

Enter the CIC

The China Investment Corporation, a 200 billion dollar sovereign wealth fund, was created in late 2007 to funnel some of China’s foreign reserves into more profitable investments. Its size is not exceptional among other global funds from Norway, Abu Dhabi, or even Singapore’s, but the speed with which it was formed makes it the new kid on the block and is seen as a carpetbagger by many countries, but chiefly the US, which fear the CIC is merely an extension of Chinese government policy abroad.

In early April, the genial president of CIC, Gao Xiqing, appeared on the US news program 60 Minutes. In a not-so-hard-hitting interview, Gao pinned down the fear foreign governments seem to have of CIC, saying “Immediately after we announced our existence, then the U.S. Government, some European governments, all came out and said, ‘okay, we think of this as — this is a dangerous — we need to do something about it. They probably want to control us. They probably want to do something bad about us,’”

These fears have stymied CIC’s investment plans. To date they’ve made only two major investments. First, a three billion stake in US private equity firm Blackstone Group, and a five billion dollar investment in Morgan Stanley at the peak of the sub-prime mortgage crisis. Not bad for six months, and only 192 billion to go.

Perhaps answering calls to speed up the pace of investment, other Chinese government entities are buying foreign assets, such as SAFE itself, which last week announced that it had accumulated about 1.6 percent of French oil firm Total S.A.’s shares, worth about 3 billion dollars. Let’s see, that only leaves, oh…. 1.67 trillion.

(Update: 4/16/08 This story showing how CIC has quietly accumulated a one percent stake in British oil producer BP. Note to China: If you’re trying to reassure the world that your SWFs are not just an extension of national energy security policy, you might want to diversify a little more. What’s next? A one percent investment in Exxon?)

With all that gold not being spent somewhere productive, the Chinese government needs to consider a new policy that will impact foreign reserves more quickly. One may hope that the new Gold Mountain won’t turn out to be the illusion it was for so many Chinese more than a century ago.

WESTERN MARKET FENG SHUI

Recently as I watch the volatile stock markets in China, more out of curiosity than as an actual investor, I am reminded of some of the stock market wisdom my father taught me, garnered from his two decades of experience as a stock broker in Canada.

As China’s Premier, the PBOC governor, and other officials rush to the press to reassure investors every time there is a fluctuation in domestic markets, I believe that what China’s markets really need is more Western-style investor education, and where better to start than with understanding the animals of the Western stock market zodiac, or what I will localize as Chinese investor feng shui.

Let’s test your investing feng shui IQ: Do South China Tigers bounce?

Near the end of March, when the markets in China were on a roller coaster, punctuated by a five percent plus drop in the Shanghai index on one Thursday and a near mirror-image rally the day after, I was reminded of the somewhat morbid concept of a bouncing cat. With all the recent purported sightings of South China Tigers, one may ask, can a big cat bounce? The answer, amazingly, is yes, if it is dropped from sufficient height. However, and this is the salient point investors need to pay attention to, the cat will then be dead. The bounce, in other words, is not expected to be of much use, least of all to the poor feline.

Traders have long used the term dead cat bounce to describe a rally or jump in a stock or market that is short-lived at best. As the Chinese stock markets have dropped dramatically from their 2007 peak, when Shanghai’s index was the world’s best performing market at 97 percent on the year, it looks possible that in 2008 their performance may be among the worst. Yet, on the way down, from so high up, we may expect there to be bounces, technical rallies, as happened that mirror-image Friday when the index gained nearly five percent after a sharp drop the day before.

If investors choose to follow this wisdom, they will not be fooled into thinking those rallies can be sustained, because the underlying fundamentals of the market decline - interest rates and inflationary pressure, reduced exports, falling corporate profits, and overall market sentiment - remain in play. With China’s political leadership collectively saying, “It’s going to be ok”, smart investors should next be asking, can you put lipstick on a pig?

Again, in stock market lore, the answer is a resounding yes! This expression means to make a bad stock appear better by using cosmetic enhancements. Such metaphorical lipstick has been put on stock market pigs for decades. Premier Wen Jiabao said to the press during his recent trip to Laos that one of the primary purposes of the government is to

“establish, through legal means, an open, fair and transparent market environment so as to protect the interests of investors and small shareholders.”

Those investors should wonder if this was merely meant to help stabilize the rapidly falling markets, and was there any real substance to the announcement?

With the Shanghai Composite Index dropping about 20 percent in the month of March alone, market talk from leaders may result in a temporary halt to the decline, but the pig is still ugly and long-term attractiveness will take much more than just cosmetics. But the political leaders’ comments beg the question, why was there so much volatility in March, anyway? Could somebody be shaking the monkeys off the tree?

Does the March sell-off indicate a healthy correction to the 2007 run-up, or is it driven by panic selling from the small investors? My father might ask, are there some big gorillas shaking the tree to make the monkeys fall out? This is one of my favorite expressions, referring to the ability and propensity of large fund and institutional investors to use their holdings to push down the values of individual stocks, even markets, by using large sell orders to panic the small investors. Later the funds come in to clean up at lower prices.

Market psychology in China’s volatile investment environment, compounded by the habit of older shareholders congregating in the brokerage lobbies and sharing stock rumors and trading tips, is especially fragile and easily distracted by short-term changes in stock price.

The small investors here should learn from their US investing brethren, who have left behind the heady days of the Dot-Com bubble and its day-trading millionaires for a return to the long-term value-investing approach. When the gorillas shake the tree, if the stock’s fundamentals and news are still strong, this can be seen as a buying opportunity to cost-average stock holdings at a lower overall valuation. So Chinese investors should save the short-term sell order and instead buy and hold for the long-term, because there are two more animals to learn from in market feng shui, the bull and the bear.

Long-time market players know there is no way to predict when to ride the market upswings - the bulls - without hitting some of the corrections - the bears. However, one thing is true over time in healthy stock markets, bulls reign over bears. Bears may lumber and growl, but they eventually go back to hibernation. Bulls, on the other hand, will always be ready to charge again. Running with the bulls, and waiting out the bears, has been the best strategy in the US stock market for the last one hundred years.

Chinese investors can learn two things from market feng shui: Old stock market wisdom can have merits, and don’t be scared of the animals.

(c) 2008 Jason Inch (Originally printed in the Shanghai Star, April 7 2008)