How to Lose Money Quickly on the ‘China Premium’

Chinese Businessman holding business card with China Flag

There are a couple of items of note today…all to do with China.

Investors got all hot and sweaty about better than expected March trade data out of China yesterday. The Australian share market surged and US stocks jumped 1% overnight, which should give our market more impetus today.

China’s exports were up 11.5% year on year against expectations of 10%, while imports fell 7.6% year on year versus an expected 10% decline.

The import data tells you that China’s economy is still weak, but not as weak as expected. Yesterday’s market reaction simply reflected the shift to this ‘less bad’ reality.

Clearly, the effect of Chinese stimulus is working its way through the system. But what happens when that begins to wane in a few months’ time? Or can we finally expect a self-sustaining recovery, as promised and expected time and time again by global policymakers?

While it’s true the global economy has experienced economic expansion over the past eight years, it’s been the weakest post-crisis expansion on record, and has come at an enormous cost. Governments are tapped out, and interest rates remain at cycle lows.

China’s economy is now experiencing just how difficult it is to recover from a credit binge. On the plus side, they do have a few levers to pull. An article in the Wall Street Journal points out an interesting way that China is trying to alleviate the pressures from its credit boom.

China is opening its $6.7 trillion bond market—the world’s third-largest—as it tries to spread the risk from its credit binge.

The opening of the bond market comes after China has allowed foreigners to buy its stocks and trade its currency, though always on Beijing’s terms. Both of those markets were opened as part of China’s efforts to liberalize its capital markets. China is opening its bond market for a different reason, to get foreigners to help in dealing with its huge debt load.

That’s the problem with China getting more deeply involved in the global financial system. In China, stability and political goals have long overshadowed financial realities. China wants to spread the risk of its markets to the world. But its markets aren’t truly markets as we understand them—they are but another political tool to be used by the central government.

The point of the article is that as China becomes more entwined with the global financial system, it poses an increasing risk to financial stability.

While that may be true, it will take some time for global capital to come into China on a scale that could prove to be a risk to financial stability. China may want to sell its dodgy corporate bonds to foreigners, but that doesn’t mean foreigners will snap them up.

For now, I reckon your best bet is to assume that China will go through a long and grinding road to slower growth, characterised by fears of a sharp slowdown followed by hopes of a renewed recovery thanks to more ‘stimulus’.

While a major economic collapse in China is certainly a risk (given the size of its credit bubble) the probability of it happening in a command economy is low. So don’t let that fear stop you from investing.

Cycles, Trends and Forecasts editor Phil Anderson wrote to his subscribers about this recently:

Investment rule number one in markets is ‘Don’t fight the Fed’. If the Fed is in expansion mode (printing money, easing rates, etc.) then trying to ‘short’ markets is the wrong side of the trade.

Likewise for China.

You are making a mistake if you are basing your investment decisions on the fear of a total Chinese economic collapse.

The Chinese cadres at the top simply will not allow it.

And they will be able to get away with it, too. Because, presently, China does genuinely have a lot of economic weaponry at its disposal to ward off a severe slowdown, if one were to develop.

China can easily lower interest rates, lower the deposit required to purchase a house, print money, or use its foreign currency reserves accumulated over many years of trading with the rest of the world.

Aside from anything else, it’s still one cycle too early in my view.

  The only caveat to this is that at some point they will run out of ammo. But that could be years down the track. As Phil says, it’s ‘still one cycle too early’. To see what Phil means and learn more about his cycle theory, click here.

While you shouldn’t let fear of a China collapse cloud your investment judgement, you shouldn’t blindly expect it to deliver you a windfall either.

Ever since commodity price boom collapsed, the China theme has progressed to the benefits of companies selling into China’s rising middle class.

Health vitamins company Blackmores [ASX:BKL] has been a prime beneficiary of this theme. As you can see in the chart below, the China tailwind pushed the share price from below $30 two years ago to a peak of $220.

[click to open in new window]

But this week the Blackmores share price came under pressure. It plunged from over $200 to below $150 at one point. The market is concerned about sales into China due to a review of Chinese e-commerce laws.

These fears may or may not prove to be unfounded. But the issue for investors is that BKL is now an expensive stock. It has a China premium built into it, and any concerns about China will savage the share price.

After generating $2.71 per share in 2015, consensus analyst forecasts suggest BKL will earn $7.88 per share in financial year 2018. That’s a 200% increase in earnings per share over three years!

While that’s achievable if China continues to deliver, BKL is already trading at over 20 times expected 2018 earnings. And it’s not a small company…its market capitalisation is already $2.8 billion.

What’s worse, the chart tells you that momentum has started to falter.

The China ride is over.

The investment lesson here is that whenever you start to see the media sing the praises of a company, you know that everyone already knows about it. And when everyone knows about it, all the good news is in the price.

There’s no point buying at that stage. You simply increase your odds of losing money on the trade. And you can lose it quickly and easily.

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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