Thursday, August 13, 2009

A Chinese Twist on the Big Mac Index

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August 13, 2009  

The U.S. market has climbed 50% from its March bottom. But that's small potatoes compared to China. The Shanghai Composite Index was recently up 103% since its November low.

The Chinese economy is awash in cash. Banks have doled out $1 trillion as part of the country's stimulus package. However, about 15% of that ($145 billion), analysts say, went directly into the stock market. Hence the super bounce.

Andrew Gordon believes the Chinese market is a bubble looking for a pin. He envisions a grim scenario:

"China could be facing its worst nightmare – the combination of a strengthening dollar (fed by rising interest rates) and a weakening U.S. economy. The Fed likely won't be raising rates this year. But next year it could. And its actions will have as big an impact on China as they do on the U.S."

Some air is already seeping out of the bubble. Since hitting its high on August 4th, the Shanghai index is down by 10%.

While the Chinese stock market may be deflating, its economic juggernaut rolls on. Imports of crude oil and iron ore hit record highs in July, MarketWatch reported.

Wall Street sees this as bullish. Merrill Lynch raised its economic forecast for China, from 8% expected growth in 2009 to 8.7%. Goldman increased their forecast from 8.5% to 9.4%.

On the surface there appears to be nothing but good news coming from China. But before you strap in and climb on the Chinese bull, there's something you should know. The Baltic Dry Index – which tracks bulk shipping costs – is pointing in the opposite direction.

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Here again, we turn to Andrew Gordon, whose value investing credentials are supported by a 20-year career in international business, some of which involved working in and around China.

During periods of high demand for commodities, bulk shipping costs go up, Andrew points out. When demand is soft, they go down. This fluctuation is measured by the Baltic Dry Index. It is the best leading indicator, Andrew says, of commodity demand. "And China's industrial activity," he says, "is the main driver of the index."

At the peak of the credit crisis last October, the index fell 90%. Then it staged a recovery, hitting new highs on June 3. Last week it fell over 17% – the worst week for the index since October. The Baltic Dry Index is down 35% in the last two months.

Some suggest shipping rates may be declining as Chinese steelmakers delay imports while they negotiate with suppliers of raw material like Rio Tinto.

But there could be an even better indicator of Chinese industrial activity than the Baltic Dry Index… McDonald's.

Worldwide, the fast food restaurant had a good month last month, but the numbers would have been better were it not for China, where same store sales have been negative for seven consecutive months.

The weakest sales in China are based in the south, where the country's thousands of export-oriented factories are clustered. When those factories start hiring again, McDonald's will show improving sales. And that will be an advance sign that China's export-driven economy is reviving.

We'll call it a new twist on the "Big Mac Index" and you can thank Andrew Gordon for the insight. If you want access to more of Andrew's money-making ideas, check out his research service, INCOME.

Due in part to the aforementioned demand in China, the International Energy Agency (IEA) raised its oil consumption projections for 2009 and 2010.

The IEA expects oil demand of 85.3 million barrels a day in 2010 – a 1.6% increase over 2009. The OPEC cartel also expects crude oil consumption to rise next year. A sign of current growing demand: U.S. crude inventories dropped 1.4 million barrels last week.

Investor sentiment is positive for energy in general as the market is focused on signals that the global economy is improving and that the Western economies could emerge from the recession by the end of 2009.

We'll take a wait and see on the economic recovery. But Investor's Daily Edge options expert, Ted Peroulakis has made the most of the strength in the energy complex.

Last month, Ted cited the increasing demand for fossil fuels. Pointing to increased factory output, gains in construction spending and other signs of economic recovery, he suggested that subscribers to his Options Power Trader to increase their exposure to energy. Ted recommended short term positions in oil and gas driller, Noble Energy, and natural gas giant, Chesapeake Energy.

Already, subscribers have closed out average gains of 108% on Noble and took half off the table for a 100% profit on Chesapeake. Ted is still bullish on the economic recovery, but he has just identified a financial company due for a fall. This stock has risen nearly 500% since February and a pullback is imminent.

If you want to profit from Ted's latest recommendation, check out the Options Power Trader here.

The 50% rally in the S&P has been fueled by less-than-horrible economic reports and still weak, but better-than-expected corporate earnings.

But while the media are on their hands and knees examining "green shoots", corporate insiders are heading for the exits. Thomson Reuters reports that corporate insiders recently pulled $53 from the market for every $1 they put in. Vickers Stock Research also tracks insider activity. They report that insider selling has now reached late 2007 levels – right before the bear began.

Nobody knows the companies that make up the market better than the insiders. And they are voting with their dollars. According to insiders, the economy is still weak and the market is headed for a fall.

Several times this week, we have suggested that a sharp pullback is imminent, but that you shouldn't try to time the market. Let your trailing stops tell you when it's time to sell.

Our colleagues at DailyWealth agree. In yesterday's issue, Steve Sjuggerud suggested the market may be headed for a blow off top before the big correction. Even greater gains could be ahead and you don't want to miss them. Here's what Steve has to say:

"If you are nervous, you can bail now. But here's what I suggest instead: Change seats. Move to a seat that's closer to the theater exit. I believe we'll see a rush for the exits sometime in the next two months. Sentiment is simply too optimistic. The trend is near its end. So we need to position ourselves close to the exits. […] We need to set our trailing stops and follow them... tighten them up if you must.

"Do what you can to keep your upside potential here... but ensure that your downside risk is minimized. The best tool for this job is trailing stops."

If you do want to take some money off the table, Steve McDonald, editor of the Bond Trader, has an idea you should consider.

Most people are a lot better at buying stocks than selling them. And after such a stellar run it's even harder to pull the trigger. But a recent Smart Money article by James Stewart suggests an easy, fundamental indicator to identify stocks where you should take profits or reduce exposure. Steve writes:

"Price/Earnings to Growth Ratio (PEG) is a good indicator of overvalued stocks. If the PEG is four (4) or higher, it's a warning sign that the stock has gotten too far ahead of its earnings and is due for a correction. The PEG is a solid, fundamental indicator of reasonable pricing."

You can find the PEG ratio for most stocks under the "Key Statistics" heading on Yahoo! Finance. If you're looking to lighten your load and reduce your risk, this is a measure you should use.

Good Investing,

Bob Irish
Investment Director
Investor's Daily Edge

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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