China's Olympian stock-market sprint

Current thinking is that Chinese markets will rally at a furious pace through the 2008 Summer Olympics -- and then investors should take the money and run. Don't bet your gold medal that strategy will work.
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By Jim Jubak

I read something in The Wall Street Journal last week that really scared me (besides the editorial page, I mean): "In Beijing, investors talk of a one-way bet on the market until at least next year's Olympics."

In other words, even though the Shanghai stock market is up 52% this year, was up 130% in 2006 and is up 305% since this rally began back in June 2005, and even though everyone knows this speculative bubble isn't sustainable, it's smart to keep pouring money into Chinese stocks -- no matter their price -- because the government won't intervene and risk crashing the market until after the showcase Beijing Olympics are over.

So invest as much as you can in anything you can until Aug. 24, 2008, the day the Beijing games come to an end. Then run -- don't walk -- in an orderly fashion to the exit.

Yeah, like that will work.
Watch out for stampede
Speculative markets that think they've got a green light to run from excess to excess until a specific date scare me. The possibility of a stampede for the exits on the Shanghai exchange starting a wave of fear that spreads around the globe scares me. And the very real possibility that the Beijing government will make a mistake and crash the Chinese stock market scares me.

Everything is not black, however. Because the Chinese stock market is, so far, only tenuously connected to the global financial market, any crash in Shanghai is likely to have only modest global effects.

With those cheery thoughts fresh in mind, let's take a look at why speculators in Shanghai think they've got a green light until August 2008.

Any explanation starts with China's massive 40% savings rate. There simply aren't very many places where the average Chinese can put that money.
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Real estate has been a popular choice recently, but the government has cracked down on speculators in that sector. Most Chinese can't invest abroad. And banks don't pay much in interest.

The Chinese government recently raised the interest rate that a bank can pay on a one-year deposit to 3.06%, a jump of 0.27 percentage point from the prior rate. Inflation is China is running at about 3%, officially. And since bank interest is taxable, the return on a one-year bank deposit is actually negative.
Everybody's doing it
So no wonder that anyone in China looking for a positive rate of return -- and who isn't, beside financial masochists? -- has turned to the domestic stock markets in Shanghai and Shenzhen. There are now 100 million brokerage accounts in China. Sixteen million of those were opened in just the first four months of 2007. Trading volumes have soared. In April, trading volume on the Shanghai exchange was twice as high as in January 2007, and in the first four months of this year volume has been seven times volume in the first four months of 2006. On May 16, trading volume in Shanghai exceeded the trading volume on all other Asian markets -- including Tokyo -- combined.

There are no signs the Chinese stock market is slowing down. What seemed astonishing when brokerage companies in China opened 300,000 accounts in a day seemed old hat when a few days later brokerages report opening 550,000 accounts in a day. The press in China is full of stories of average citizens who have doubled their money. The Chongqing Morning Post recently featured a 60-year-old cleaning woman who had doubled her 20,000 yuan (or about $2,800) nest egg in two months. "At a time like this," the paper quoted her as saying, "who can lose money?"
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Global market blowup
Sure, the Shanghai stock market could melt down, but China isn't the only economy that could be in trouble. MSN Money's Jim Jubak says India, Japan, Europe and the U.S. are all on his shortlist of regions that could face a setback.


The central government in Beijing isn't happy about this. Officials have tried talking the market down without success. Central bank governor Zhou Xiaochu was quoted expressing "concern" in the People's Daily and no one blinked. Interest rate increases haven't slowed the river of cash flooding into stocks. Leaks that say the government is studying raising the tax on capital gains haven't worked, either.

Why is the government worried? Because China has been down this road before. A boom in 1999 drew in millions of new investors who were then wiped out when prices plunged in 2001.

This boom is even bigger. And the fallout from any sudden bursting of the bubble is likely to be immense.

The stock-market boom has made many Chinese richer, and that has led to a surge in buying: In effect the recent acceleration of the Chinese economy to a better than 11% growth rate has been fueled by the stock bubble. Taking away this stimulus will slow economic growth, although no one knows by how much.

The bigger danger, though, is the amount of debt racked up by individuals, companies and even government agencies in their frenzy to get a piece of the Shanghai action. It's hard to get any real figures on the use of debt to buy stocks, but what we do know is worrying. Common are anecdotes like that of Xiao Feng, reported in the Nanjing newspapers, who borrowed against his three apartments and two cars to buy stocks. In Shenzhen, newspaper editor Qi Xiaotong put her family home up for collateral for a loan of 1.3 million yuan (about $175,000) that she then used to buy stocks. "I don't think there is any risk at all, because I have already doubled my money," she told The Guardian.

Shenzhen News Net reported the story of another Nanjing man who mortgaged his apartment to raise 60,000 yuan (roughly $8,000) to buy stocks.

And irresponsible trading clearly isn't limited to individual Chinese. In mid-May, the Shanghai Municipal Housing Maintenance Funds Management agency, which cleans drains and repairs elevators in city apartment buildings, was revealed to have put about $103 million into the Shanghai stock market -- in spite of a ban on such investments. Estimates put the total stock-market investment by army and police units, local governments and state-owned companies at $125 billion.
The Party leery of ending the party
The government could bring the Shanghai market to its knees by raising interest rates on bank accounts -- thus diminishing that cash flow -- and increasing capital gains taxes at any time of its choosing. So why hasn't the government moved to snuff out at least some of this speculation?

Because moving in anything other than baby steps could unleash a storm of social unrest in China. The kind of wealth created by the stock-market boom is pretty much all that legitimizes Communist Party rule these days. The social contract in China now runs along these lines: Give us rising incomes, more things like those people have in the developed economies and a reasonable degree of stability, and we'll let you run the country. If the Communist Party can't deliver its part of the bargain, however, no one knows how much force it would have to apply to ensure its continued hold on power.
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The cynics trading on the reluctance of the Beijing government to rock the boat before the Olympics in August 2008 are absolutely correct. The games are a huge prestige event for China's rulers and they very much want to avoid anything that might increase the odds of embarrassing demonstrations in front of an international television audience numbering in the billions.

But after that? All bets are off. I'd expect to see further increases in interest rates and further loosening of limits on overseas investment by Chinese citizens. The model is the Qualified Domestic Institutional Investor plan launched in Hong Kong last June. It hasn't been very popular to because the returns from investing in China have so far outstripped returns from overseas markets that most Chinese investors don't see the point. But the effort is part of what China needs to create in order to tame domestic stock-market speculation: Other investment opportunities besides the Shanghai casino.

At best, the effect of all of this will be a gradual slowing of the gains on the Shanghai exchange early in 2008 as investors move to the sidelines in an orderly fashion in anticipation of the post-Olympics changes. At worst, we'll see a mad rush for an exit at a completely unpredictable point in time ahead of the games as some rumor panics investors into selling all at once. Remember, Chinese investors expect Beijing to act. They're already trying to time their exit.

A 1987-style crash in the Shanghai stock market would be a disaster for individual Chinese investors. Some would see their entire stock-market wealth disappear overnight. Some would see their entire stock wealth and their homes vanish in a single rush. The Chinese economy would be knocked for a loop.
Video on MSN Money
Global market blowup
Sure, the Shanghai stock market could melt down, but China isn't the only economy that could be in trouble. MSN Money's Jim Jubak says India, Japan, Europe and the U.S. are all on his shortlist of regions that could face a setback.


But the Chinese government has the financial reserves to restore confidence in the stock market and the economy in quick order, just as the U.S. Federal Reserve did after the October 1987 crash in the United States. I'd expect economic growth in China to rebound relatively quickly. Still, I worry that such an event would produce a surge in social unrest as the losers in the crash demand redress. The level of domestic protest -- and the amount of routine violence employed to quash it -- has been steadily on the rise in China in the past few years.
The world won't end
And the effect on other markets? Limited, I think, after an initial empathetic panic. Because China's financial markets remain relatively closed to most foreign investors, only a relatively few big overseas financial institutions would take much of a hit. International companies could see their Chinese partners go under and be forced to ride to the rescue, and it's possible that big investment houses in New York and London have derivative contracts out with Chinese institutions that would take a bite out of their bottom lines. But I don't see any exposure large enough to send a non-Chinese company spiraling down in the wake of a Shanghai meltdown. And that's the kind of event needed before the crash would spread.

But all this can change. If the Chinese government indeed doesn't act until September 2008, the bubble will be even more overinflated when it does. If the crash doesn't come until late in 2008, that's another 15 months for U.S. financial institutions to deepen their involvement in the Chinese financial markets.

In short, I don't think a Shanghai stock-market crash, as bad as it would be, is the kind of end-of-the-financial-world-as-we-know-it event that the doomsayers are calling for.

But I'm sure keeping my eye on China and its bubble.
Updates to Jubak's Picks
Sell Yahoo (YHOO, news, msgs).

Yahoo's greatest strength, branded online advertising, is under attack. The recent acquisitions of aQuantive (AQNT, news, msgs) by Microsoft (MSFT, news, msgs), the parent of MSN Money, and of privately held DoubleClick by Google (GOOG, news, msgs) are aimed right at Yahoo's leading 10% share of the market for branded advertising on the Net. Panama, Yahoo's new search-ad sales platform, is intended to let Yahoo fight back against Google in the market for search-based ad sales. There Yahoo trails Google with a 20% share in the first quarter, down from 25% in 2006. But in the still very young and fragmented -- Microsoft was No. 2 in the market with an 8% share in 2006 -- branded-advertising market, Yahoo's huge user base of 500 million has been a huge advantage. Since Yahoo knows so much about the behavior of these users, brand advertisers have been willing to pay up to ensure their ads hit exactly the right audiences.
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But in their acquisitions, Google and Microsoft have leapfrogged Yahoo by buying huge behavioral databases that rival Yahoo's in size but are built on data from across the Web rather than on the behavior of Yahoo users alone. I don't know whether that is a compelling strategic advantage in the long run, but I do know that defending its turf from Google and Microsoft will put pressure on a company that has struggled to execute in recent years. (And you'll notice, if you look at a price chart, that the stock has broken down again.) Better management at Yahoo could lead a strong counterattack, given the company's strengths, but I'm not willing to bet on the current team against the competitive field. As of May 29, I'm selling Yahoo out of Jubak's Picks with a loss of 16% since I added the shares in February 2005. (Full disclosure: I will sell my personal shares of Yahoo three days after this column is posted.)
New developments on past columns
"The 5 best stocks for 2007": Procter & Gamble's (PG, news, msgs) May 1 report on third- quarter earnings for the company's June 2007 fiscal year didn't do the stock any good. Shares fell by 4.5% from April 30 through May 10. I call this a buying opportunity. If you're looking for a blue-chip consumer products company to ride through the turmoil created by what seem to be (at the moment) rising interest rates and falling economic growth, you can't find a better horse than Procter & Gamble. Investors in Procter & Gamble are used to upside earnings surprises, and when they didn't get one in the third quarter, they sold. Not that the quarter was bad. Revenue climbed 8.3%, and organic sales (that's total revenue minus revenue from acquisitions) were up 6%. Earnings from operations grew by 12%. In its post-announcement conference call, the company confirmed earnings guidance for the 2008 fiscal year of $3.47. That would mean 14.5% growth in fiscal 2008 on top of Wall Street's projections for 13.5% growth in fiscal 2007. The shares sell for 20.7 times projected fiscal 2007 earnings per share. You have to go back to 2005 to find a time when the stock was cheaper. As of May 29 I'm keeping my target price at $72 a share but stretching out the timetable to December 2007 from the prior September.

Editor's note: A new Jubak's Journal is posted every Tuesday and Friday. Please note that recommendations in Jubak's Picks are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest rate environment, see Jim Jubak's portfolio of Dividend stocks for income investors. For picks with a truly long-term perspective, see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio. E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Yahoo. He did not own short positions in any stock mentioned in this column.