Excess Capacity in China Defies Surging Stock Prices

Montreal, Canada

Betting against a market or an index is always difficult. Warren Buffet has always exclaimed that investors betting against America always lose money over the long-term. And the worst hedge fund category in the 1990s and earlier this decade prior to the 2008 Panic belonged to the short-sellers or hedge funds that have a dedicated short-selling mandate.

Historically, betting against stocks has been a one-way train to the poorhouse. But these are not normal times. From late 2007 until March 2009 short-sellers and reverse-index ETFs made speculators a fortune as the financial system almost collapsed. Reverse-index funds are now trading at 52-week lows.

The recovery now underway since March has been parabolic without any sense of logic; stocks have not suffered a correction – typically at least a 10% decline and generally viewed as a healthy development – over the last six months and show extreme overbought conditions. The market isn’t cheap, either.

I’m convinced China is the Mother of all asset “bubbles” in 2009. You can also claim the same for the majority of risk-based assets worldwide as a gusher of central bank liquidity and institutions trailing the market rush back into stocks since June. September, the worst month for the stock market historically, has been a winner this year aided by investors seeking to raise equity allocations head of September 30 quarter-end.

Heading into this morning, the MSCI World Index of advanced industrial economies has now surged 52% since March 1 while the MSCI Emerging Markets Index has skyrocketed 83% over the same period.

One of the best macro hedge fund Managers in the world recently wrote a commentary I wanted to share with you on China. This Manager has earned more than 20% per annum since 2000 running his own hedge fund and is suffering his first loss in ten years because he’s still bearish. Prior to 2000, he ran a long-only global stock fund at GAM and earned double-digit returns for more than a decade:

“There are, I believe, reasons to be doubtful about the durability of China's stimulus plan and the benefits it might bring to the wider economy, particularly as to any growth in corporate profits in China. One of the striking elements to the China story is just how large many of her basic industries such as steel and cement have become and just how much excess capacity now exists. To put this into perspective; China has capacity to produce some 660 million tons of steel per annum, more than the EU, Japan, the US and Russia combined with another 60 million tons of capacity currently under construction. She currently produces around 500 million tons, suggesting that idle capacity exists equivalent to the total of Korean and Japanese output. China's consumption of steel is already equal on a per capita basis to the EU and higher than the US, raising the question as to just how much higher steel consumption can go. Despite China's efforts to stimulate, Chinese steel companies are racking up large losses.

Some sources suggest that as much as 90% of China's first half growth in GDP was accounted for by growth in capital spending. This all begs the question that with global trade shrinking, or at best, stagnating, can the Chinese government ensure that the growth story does not derail? At the very least some discounting of a possible slowdown seems possible, something which is quite alien to a stock market trading in excess of 20x 2010 earnings.”

Betting against a freight-train is hard. That’s how to best define what’s happening in Chinese stocks since last November when Shanghai bottomed. Still, it’s instructive to warn that the world is growing more correlated to the Chinese economic cycle – a dangerous correlation because her economy is still a loose cannon and local stock exchanges remain one massive casino. It’s also one of the few economies in the world since 1993 which shows no direct correlation between GDP growth and the stock market; a big bust lies ahead for Chinese equities even if the economy continues to expand.

In the 2000s, the Shanghai Composite Index crashed on two separate occasions even though Chinese GDP continued to expand vigorously; it’ll crash again.

Comments

[Wes Neal]

Dear Sir,

First, my apologies for being nearly four months late to your topic. However, as are many of your topics, it's still relevant today. I wonder if you're familiar with the work of Dr. Stephen Leeb? In his January 2010 issue of The Complete Investor, he makes a very compelling case in the opposite direction on China.

The component of his opinion that rings most true, is the notion of China's accute awareness of being in competition (read 'at war') over resources with the 'West'. This certainly includes the resources required to build 720 million tons of capacity for steel processing. By the way, how many people live in the EU, Japan, US, and Russia and how much steel processing tonnage do they need for internal consumption as opposed to a Chinese regime with a propensity for insular thinking?

Any additional thoughts would be appreciated.

Regards,
WTN

[Stocks To Buy Now]

I tend to agree with you. I just can not see how China can continue it's growth when all this extra capacity has to shut down. Stimulus may help to keep some of it going, but that can only go so far.