Wednesday, August 19, 2009

The Chinese Bear Market Starts Now; Has U.S. Housing Bottomed?

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August 19, 2009  

There is no "official" definition of a bear market. But it's widely accepted that a 20% drop in a major index constitutes one. The Chinese market just crossed that line…

Last week, we warned you that China was a bubble looking for a pin. At the time, some air had already leaked. The Shanghai Composite Index was down by 10% from its high on August 4th. Last night, the index briefly dipped below the 20% threshold that marks a bear market.

At its recent peak, the S&P 500 was up 50% from the lows in March. But Chinese stocks more than doubled from their lows. After a run like that in a major index, selling seems like a rational idea.

But that's not what Shanghai-based money manager, Larry Wan thinks. He oversees about $583 million in assets. Wan says that it is "irrational selling that has shattered market confidence."

He concludes that some mutual funds are reducing their stock holdings because they are "pessimistic about the economic outlook." That doesn't sound irrational at all. And it's funny. We don't recall Wan complaining about "irrational buying" that drove the Chinese stock market up 103% in nine months.

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What is truly irrational is that the Chinese authorities did not allow the market to liquidate the mistakes of the first bubble.

Instead, they pushed a stimulus plan which forced Chinese banks to make loans to state-preferred companies. The bulk of the money has gone into massive construction projects. Many of these projects were completely unnecessary and are now sitting empty. And many of these loans will not be repaid.

As much as $145 billion of the Chinese stimulus money has gone directly into the stock market. According to Bloomberg, the Shanghai index is trading at 30.4 times reported earnings. That is after the recent decline. And it is still almost double the 17.5 times earning multiple on the MSCI Emerging Markets Index.

The ProShares UltraShort China ETF (FXP) was over $180 a share when the Chinese market hit bottom in November last year. Today, the FXP trades for around $11. If you're looking to short the new bubble in China, this is one way to play it. But keep in mind, this is a leveraged fund. Watch your position size.

U.S. politicians embarked on our own emergency stimulus plan. And if you ask the average man on the street, he'll tell you it's not working. That's what USA Today did.

A USA Today / Gallup Poll found that 60% of adults believe the stimulus plan won't help the economy in the years ahead. Only 18% believe it has done anything to help their personal situation.

Almost half of those polled say they are "very worried" that the stimulus money is being wasted. Ha! We're talking about a government program. What do they expect? And who are the other half who believe the money is being well spent?

IDE analyst Andrew Gordon suffers no such delusions…

He notes that companies made it through the second quarter with massive cost cuts. But revenue and earnings growth was a no show. As for "what's next", Andy listed four too-good-to-be-true scenarios...

  1. An export surge that lifts the larger U.S. companies with global operations
  2. A housing rebound, as prices finally become affordable again
  3. Billions in private-equity washes into the market, lifting all boats
  4. Another huge government stimulus package

The only one of these that has a chance of happening, according to Andy, is another government stimulus package. But if the public hates the first one, they won't be clamoring for a second. And turning to failed policies is never a good sign. If a second stimulus package is passed, he says, "It will be a sign of how desperate we've become and how bad the economy is."

The past five months have been an earnings multiple rally. Earnings have actually declined during this period. Investors are paying more for companies during a time when the economy shrank 1%.

The only explanation is that investors are pricing in a quick economic recovery. If they are wrong, the market will take back much of its recent gains. Andrew believes this rally has been a "huge leap of faith and is completely unsupported by what's going on in the economy."

He points out that people are still losing several hundred thousand jobs a month. Consumers and companies are still cutting back on spending. And it is simply too much to expect the economy to resume a 3-5% growth rate anytime soon.

"Swallowing Wall Street's pie-in-the-sky optimism would be a grave mistake," he writes. "The market has gone up too fast too soon. A fall back is unavoidable. I expect the S&P 500 to revisit the mid-500s in the next few months."

But there is one group of companies that consistently out-perform the market, especially during a downturn. These are companies that have consistently raised their dividends for many, many years. Even in this tough earnings environment, quite a number of companies are still rewarding shareholders with rising cash payments.

In his research service, INCOME, Andrew has identified the best of the best. To learn about his latest ideas and recommendations, click here.

For there to be any sustainable recovery, the housing market must pick up. And we're beginning to see some signs of life.

In June, sales of new homes rose by 11%, the biggest increase in eight years. Sales of existing homes increased 3.6%. Building permits are also up. And new home construction rose 2% last month. It was the fifth straight month that this indicator has gone up. New home construction is up 37% from its low this past winter and is expected to help the economy for the first time in over three years.

The brightest news may be that two states hit hardest by the housing bubble – Florida and California – saw improvements this past month. And the median new home is $30,000 cheaper than before the big bust. That makes owning a home more reasonable for a lot of buyers.

"Housing is no longer a drag on the economy" says Mark Vinter, a senior economist with Wells Fargo, "and that's a good thing." The world's economies nearly imploded last fall. And it was the housing market that led the way. It's reassuring that housing is finally showing signs of life.

But it's not all roses yet. The industry is off 70% from its high in 2006. And there are several dark areas that will put off a full recovery for quite a while.

Sound Profits editor, Steve McDonald, points out that unemployment is still expected to reach 11%. That means more people who can't pay their mortgages. Also, the 10% tax credit for of the cost of a new home (up to $8,000) is due to run out in November. And the real estate market still has a large supply of low-priced foreclosures, which should keep prices suppressed.

But the good news is the shift seems to have started. A mixed bag of data is expected at this point in a recovery. Finally, Steve writes, "If we see a strong selloff in the markets this fall, it will be time to take a look at the homebuilders. Most of the numbers are pointing to a big value play here."

To learn more about Steve's latest ideas and recommendations, check out Sound Profits here.

Good Investing,

Bob Irish
Investment Director
Investor's Daily Edge

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Bob Irish - Investment Director
Andy Gordon - Editorial Contributor
Jon Herring - Editorial Director
Ted Peroulakis - Editorial Contributor
Christian Hill - Managing Editor
Dr. Russell McDougal - Editorial Contributor
Steve McDonald - Editorial Contributor
Michael Masterson - Editor Emeritus


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