Chinese Policy Shifts Investors Need To Know About

• May 6, 2005
• Mark Boucher

Chinese
Clues

The Chinese government has made
some strong shifts in policy aimed at a very ambitious task — reorienting demand
toward consumption and away from capital investment in order to simultaneously
cool off the overheated sectors of the economy while boosting the laggards at
the same time attempting to keep growth overall strong.

So far the shift is working
remarkably well. Capital Spending’s contribution to GDP growth has dropped from
over 80% near the end of 2004 to almost 40% so far this year.  Consumption’s
contribution to GDP growth has exploded from under 25% to nearly 50% in the same
period. Yet real GDP growth remains an extremely strong 9.5%. However the policy
shift is not over.  In fact, since fixed investment is still expanding at over
20% rates and power shortages have dropped but are still occurring, the
authorities are unlikely to stop efforts to contain capital spending. 

China is now a big enough
influence, particularly at the margin, that the impact of its policies needs to
be a consideration for investors. There are several noteworthy economic and
financial implications of this policy shift that investors should monitor and be
aware of.

First of all, Chinese import
growth should continue to slow, despite continuing strong overall economic
growth. Particularly imports of capital goods will remain under pressure. This
is one reason Japan’s economic growth has faltered, as its machine tools exports
have slumped. Korea’s exports to China have slumped as well, and investors
should expect the rest of Asia to feel the pinch from Chinese slowdown in
capital investment, as this is the region that exported to China so abundantly
in this area.

Secondly, while China’s imports
of raw materials may slow, its structural dependence on imports of natural
resources means that imports here will not slow nearly as much as those of
capital goods. Chinese imports of rolled steel has plummeted to nearly zero, yet
its imports of iron ore to keep domestic Chinese steel mills operating at full
capacity continue strong. 

Third, if the new trend of
accelerating household spending can be maintained it will help balance global
demand, ease the current account excess in China, and help diminish the US’s
need to be consumer of last resort.  In addition some household products
companies like PG, KO, CLX and others that have strong exports to China could
experience demand increases that the market has not yet fully priced in, leading
to a continued and growing outperformance of staples over the market and over
global capital goods and basic industry stocks. So far soft drinks, soaps and
other staples have begun to outperform the market, and we suspect that if
China’s policy continues to work, this trend will continue. XLP and other
indexes of staples should do well versus capital goods in Asia and versus the
market as a whole.

Just when this market looks
like it’s going to break down, it doesn’t.  Recall that as of last week we were
 awaiting a close by the Nasdaq below 885 (happened), accompanied by an SPY
close below 113 (didn’t happen), and a DIA close below 100 (didn’t happen)  to
confirm a new leg down in progress and establishes a clear downtrend here.
Instead the market has reversed up in the nick of time, though volume has not
been outstanding.  As we’ve been suggesting for some time, this is a trading
range mess that is toxic to trend trading strategies and likely to remain that
way until the Fed eases up on tightening and fears of a slowdown dominate market
opinion.    

We still like health care,
Defense/aerospace, and some staples over the market and over weaker groups; 
while the best short-side groups appear to be home retail, discount retail,
electronics and computer retail, and restaurants. Several of our favorite
short-side groups have embarked on bear rallies that investors should avoid for
now.  We still suggest fairly balanced long/short mix although the bull side
deserves a SLIGHT bias here.  Notice how quickly bonds fall off and the dollar
declines when global equity market rallies. I suspect this means that strong
sustainable advances are unlikely in a self-correcting market environment that
seems mired in a prolonged trading range with volatile moves in both
directions.  Continued Fed tightening appears likely as well and the market is
likely to have difficulty embarking on a sustained advance of any significance
in this dangerous environment.  However the opposite also appears to be the
case.  Any time stocks begin a decent decline, bonds rally sharply, acting as a
stabilizer.  As long as this stabilization back and forth among major markets
continues, big sustained moves become less likely.

Our model portfolio followed in TradingMarkets.com with specific entry/exit/ops
levels from 1999 through May of 2003 was up 41% in 1999, 82% in 2000, 16.5% in
2001, 7.58% in 2002, and we stopped specific recommendations up around 5% in May
2003 (strict following of our US only methodologies should have had portfolios
up 17% for the year 2003) — all on worst drawdown of under 7%. This did not
include our foreign stock recommendations that had spectacular performance in
2003. 

This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 16, 20, 39, 33, and 46 with 21 breakouts of 4+ week ranges, no
valid trades and no close calls. This week, our bottom RS/EPS New Lows recorded
readings of 73, 82, 28, 27, and 12 with 15 breakdowns of 4+ week ranges, no
valid trades and no close calls. Valid signals remain in place in LCAV and CHTT
on the long side and ALO and BOBE on the short-side. Notice that neither new
highs or new lows are exceptionally strong this week, AGAIN. 

For those not familiar with our long/short strategies, we suggest you review my
book

The Hedge Fund Edge, my course “The
Science of Trading,”

my video seminar, where I discuss many
new techniques, and my latest educational product, the

interactive training  module.
Basically, we have rigorous criteria for potential long stocks that we call
“up-fuel,” as well as rigorous criteria for potential short stocks that we call
“down-fuel.” Each day we review the list of new highs on our “Top RS and EPS New
High List” published on TradingMarkets.com for breakouts of four-week or longer
flags, or of valid cup-and-handles of more than four weeks. Buy trades are taken
only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts
are similarly taken only in stocks meeting our down-fuel criteria that have
valid breakdowns of four-plus-week flags or cup and handles on the downside. In
the U.S. market, continue to only buy or short stocks in leading or lagging
industries according to our group and sub-group new high and low lists. We
continue to buy new long signals and sell short new short signals until our
portfolio is 100% long and 100% short (less aggressive investors stop at 50%
long and 50% short). In early March of 2000, we took half-profits on nearly all
positions and lightened up considerably as a sea of change in the
new-economy/old-economy theme appeared to be upon us. We’ve been effectively
defensive ever since, and did not get to a fully allocated long exposure even
during the 2003 rally.

My advice remains: Tread lightly and carry a big wad of cash awaiting a better
odds environment. A soft landing later this quarter could set the stage for some
fantastic opportunities down the road a ways.

 Mark Boucher