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Where Does Hot Money Go Next?


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

MINYANVILLE ORIGINAL China's economy faces many challenges going forward. The slowing world economy has dampened demand for Chinese exports. According to the New York Times, signs that the Chinese economy is sputtering continue to mount in the form of dismal and feeble trade data, fanning expectations that Beijing will soon step up its efforts to buttress growth before a key leadership transition this autumn.

Compared to GDP growth in the US, Europe, and Japan, the Chinese growth rate, although declining, is enviable. China's economy fared better than many expected in 2011, and has emerged as a key driver of global growth. Despite the slowdown, it remains, according to the Carnegie Endowment's International Economic Bulletin, the world's best- performing large economy and the strongest economic engine.

Why then is the Shanghai Stock Exchange ($SSEC) posting such poor performance?

Click to enlarge

One key to understanding this picture is China's emerging middle class. According to a recent article in CNNMoney, the Chinese middle class comprises households with an annual income of between US $10,000 and $60,000. A rule of thumb is that a household with a third of its income for discretionary spending is considered middle class.

The CNNMoney article goes on to say this about the Chinese middle class:
Most middle class people in China have a college education and relatively stable jobs. There are a lot of entrepreneurs and a lot of white collar workers working for multinationals or state-owned companies.

They are a lot younger ... 20 to 50. A lot of them own homes. Like Westerners, they want everything Americans have.

This new middle class just emerged in the last 15 to 20 years. Fifteen years ago, people didn't have cars yet. But in the last seven, eight, or nine years ... everyone has a car. Some people have more than one car.
So the emerging middle class in China has been buying "the American Dream."

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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