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Where Does Hot Money Go Next?

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A look at recent changes in China's economy and the Chinese middle class.

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Although members of the Chinese middle class are well educated, they seem to be less savvy in their investment portfolios. As Chinese stocks tumbled, they invested in Chinese real estate, which has also been tumbling.

In July, news broke of a massive illegal gold-futures trading scam in China. According to a report in China Daily, 5,000 investors were bilked out of 380 billion yuan ($59.62 billion) in a scheme involving Loco London Gold dating back to 2008. Although the newly-minted Chinese middle class has a natural cultural affinity towards gold, this was a new experience for many.

According to the World Gold Council, gold demand in China skyrocketed to record levels in the first quarter of 2012. Additionally, China is expected to overtake India as the largest market for gold this year. Yet the average Chinese investor has been late to the table when it comes to investing.

There is, however, another type of investor that is savvy to the ways of the world and able to afford good counsel when it comes to investing. This investor (or actually his money) travels globally to find bargains that are ignored by the average investor and is willing to take chances when others are not. This is patient money, because, once committed, it waits for the rest of the investment community to catch up to his or her way of thinking. We call it "Hot Money."

One such potential target for the next move by Hot Money is the Shanghai Index, or China A Shares. Take a moment to think about this: The Shanghai Index has been in a secular decline since 2007. Since the rally in 2009, there have been three nearly unbroken years of decline. The P/E Ratio has fallen from nearly 75 at the market peak in 2007 to 11.03 on August 31, 2012 (source: Bloomberg). Contact with the lower cycle band on the weekly chart portends that a washout may have already taken place. It would not be unusual to see a bounce that may expand the P/E back to 15-17 times earnings, even though China may still be in a secular bear market.

China A Shares are available generally for purchase by mainland citizens; foreign investment is only allowed through a tightly-regulated structure known as the Qualified Foreign Institutional Investor (QFII) system. Several major brokerage firms have been able to make inroads into this market through QFII and bring the opportunity to trade China A Shares to the US market. One such investment product is the ETF: Morgan Stanley China A Share Fund (CAF). It is a liquid ETF with a market cap of $391 million, and tracks the Shanghai Index (000001.SS) with a high degree of correlation.

It appears that the Chinese government is committed to further opening up its capital markets. In July, the amount available for QFII was raised by $50 billion, taking the total to $80 billion -- an unprecedented step for the Chinese authorities. Once Hot Money latches on to this opportunity and others follow, we anticipate that CAF will appreciate rapidly.

See more from Anthony M. Cherniawski at The Practical Investor, and more from Janice Dorn, M.D., Ph.D. at Trading With Art and Science.
Position in CAF.
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