STOCKS: Sell Emerging Markets
As we are writing this, on January 20, an off-hand comment by a Chinese regulator has caused global markets to crash. China intends to take steps to restrict lending and to avoid dangerous bubbles from forming in Chinese real estate.
BULL IN CHINA SHOP
Of course, central banks tend to be a bit clumsy when trying to cool overheated markets. The art of slowing an asset bubble without causing it to burst violently is a delicate one, and over the years Chinese policymakers have proven to be more adept at crushing ants with sledgehammers. In other words, we don’t think this will end well.
LOOK OUT BELOW
To us, China’s lending curbs are the straw that breaks the camel’s back, and we recommend that investors short China and emerging markets using the Powershares Emerging Markets Infrastructure Fund (PXR).
CONTAGION
It is our fear that a crash in China will spill over into a broader emerging market crisis, and we believe that any such crisis would hit the construction and infrastructure sectors the hardest given that these have been the centers of speculation. This leads us to choose PXR as our short target rather than the more popular EEM or FXI.
THE MIX
PXR’s market cap is 15 percent China, 12 percent Brazil, 9.1 percent South Africa, 8.9 percent Indonesia, and 8.2 percent Russia. With the exception of Brazil, we consider all of these countries to be high risk at current levels.
CAUSE FOR CONCERN
Our skepticism of emerging markets in general and China in particular is based on several factors.
First, the view is nearly unanimous on the Street that emerging markets are the place to be invested in 2010. The “themes” that have been appearing with increasing frequency are the relative decline of the United States and the rise of emerging market giants like China, India, and Brazil. The Pragmatic Capitalist did an excellent job of aggregating the 2010 forecasts from the major Wall Street banks.
It seems that every bank on Wall Street—even those that are bearish—seem to have a positive view on emerging markets. As natural contrarians, we would view this as a signal to bet the other way. When “everyone” is bullish on a given asset class, there is no one left to buy.
Second, China is starting to draw the attention of some significant contrarian short-sellers. James Chanos, who made a name for himself by shorting Enron and Tyco before their respective implosions, is actively betting against China. And he is doing so specifically by targeting infrastructure stocks, which he sees as being the most vulnerable.
Finally, Pivot Capital Management published an excellent report outlining how truly excessive China’s capital spending boom has been. Pivot found that 70 percent of China’s GDP growth was due to capital spending in 2008, and a ridiculous 90 percent of GDP growth in 2009. To put things in perspective, China’s investment rates far exceed those of even post-WWII Germany and Japan!
THE TRADE
Sell PXR short if it falls below its recent support level between 41.50 and 42.00. Emerging markets can be volatile, so protect yourself with a stop loss. If PXR closes at a new 52-week high above 46.27, cover your short. See Figure 1, courtesy of Yahoo Finance.