Three investment strategies
To see why, it is probably useful to understand how investors make trading decisions. This blog entry is going to be a pretty abstract piece on how I think about the underlying dynamics of a well-functioning capital market, and how these apply to China. I have spent the past three days in Spain to celebrate my mother´s 80th birthday, and while here I have been reading Steve Fraser´s excellent cultural history of Wall Street. Re-reading stories about some of the craziness on Wall Street during the 19th Century brings to mind some of the equal craziness in the Shanghai stock markets, and made me think about how markets perform as allocators of capital.
Arbitrage or relative value traders exploit pricing inefficiencies to make low-risk profits. They ensure that markets provide clear pricing signals and, perhaps less acknowledged but more important, they link up assets into a single market by spreading buying or selling in one asset across the asset class. In other words if one asset is heavily purchased, its price will not rise relative to other assets in the same class because as it does, relative value traders will sell that asset and buy the others in its asset class. This forces the market to function as a unified market, rather than as a series of unlinked markets for each individual asset.
Finally fundamental or value investment strategies involve buying assets in order to earn the economic value generated over the life of the investment. The role of this strategy is to channel capital to its most productive use, and it is the decision to confiscate capital from less profitable companies and channel it to more profitable ones that creates the mechanism which allow markets to predict the economic future.
It is the latter strategy – perhaps most famously characterized by the likes of Warren Buffet – that gives the market its predictive ability. By constantly switching out of assets with diminished cash-flow expectations and into assets with rising cash-flow expectations, fundamental and value investors turn the market into a machine that discounts long-term cash-flow expectations, and in so doing, makes predictions about the future. The level of market prices is the sum of these predictions.
Adding and subtracting volatility
Most investment consists of one or more of these strategies combined (although I did once meet someone who traded on the basis of the Zodiac, which I don’t think fits into my model), and they have different impacts on market volatility. Speculators, for example, are often “trend” traders, looking for many opportunities to make small profits, or they try to take advantage of information – such as government signaling, regulatory changes, or changes in liquidity or technical factors – that will move markets in the short term, even if only temporarily. Since they often use leverage, they automatically see their buying power increase as asset prices rise, and are forced to sell when prices drop. All of this means that speculators tend to buy in rising markets and sell in falling ones and this behavior, by reinforcing price movements, can increase market volatility.
Value investors typically do the opposite. They tend to have fairly stable target price ranges, and when an asset trades below or above the target price range, they buy or sell, thereby countering market volatility. For them information consists of anything that might affect the long-term cash generating ability of an asset, or anything that affects the appropriate rate at which to discount the cash flow. They need good macroeconomic data, good financial statements, and a strong corporate governance framework.
Relative value traders look for assets that are mis-priced relative to equivalent assets, and they buy and sell simultaneously to lock in small, low-risk profits. Like fundamental investors, they need good data with which to make relative value comparisons. They also need relatively low frictional trading costs and the ability to short.
A well functioning market requires all three types of investors. Without all three, markets lose their social value of ensuring that economically beneficial projects have access to cheap capital. A market dominated by speculators, for example, tends to be volatile and inefficient at allocating capital.
This is because speculators focus largely on variables that may affect short-term demand or supply for the asset, such as changes in interest rates, margin levels, political and regulatory announcements, or insider behavior. They downplay the importance of long-term economic information, except to the extent that it might affect other investors (a form of the Keynesian beauty contest). Moreover since their investment horizons are short, they can ignore the impact of high discount rates. In a market dominated by speculators, prices can rise very high or drop very low on information that may have little to do with economic value and a lot to do with short-term non-economic behavior.
Value investors, however, keep markets stable and focused on growth. For value investors, short-term non-economic variables are not an important or useful type of information. They are more confident of their ability to discount economic variables that affect cashflows over the long-term. Furthermore, because the present value of future cashflows is highly sensitive to the discount rate used, these investors spend a lot of effort on developing appropriate discount rates.
Who can play?
China does not have a well-balanced investor base. There are almost no arbitrage or relative value traders because they require low transaction costs and the legal ability to short securities, which has only been permitted on the mainland recently and is severely restricted. There are also very few value investors. The vast majority of investors in China tend to be speculators. This makes the Chinese capital markets fairly volatile and very poor at rewarding companies for decisions that add economic value over the medium or long term.
Why are there so few value investors in China and so many speculators? The answer lies in the kind of information that can be gathered in the Chinese markets and how the discount rates investors use to value this information are determined. If we broadly divide information into fundamental information, used for making economic decisions about long-term cashflows, and technical information, which covers short-term supply and demand factors, it is obvious that the Chinese markets provide a lot of the latter and almost none of the former. The ability to make value decisions requires a great deal of confidence in fundamental information, like the quality of economic data and the predictability of corporate behavior, but in China today there is little such confidence.
Poor macro data, inaccurate financial statements, a weak corporate governance framework, and many of the very factors that make speculation such an exciting game in China, make it difficult for relative value investors, and nearly impossible for fundamental and value investors, to ply their trades. With interest rates heavily controlled by the People’s Bank of China, and subject to policy shifts, investors are not even sure what an appropriate long-term discount rate might be.
When it comes to technical information useful to speculators, however, China is very well endowed. Insider trading is common in China. Opaque corporate governance and ownership structures can cause sharp fluctuations in corporate behavior. Illiquid and fragmented markets allow determined traders to cause large price movements. In addition, the single most important player in the market, the government, often behaves in ways that are not subject to economic analysis.
Non-economic players
This has a very important effect on undermining value investment and strengthening speculation. In the first place, unpredictable government intervention causes discount rates to rise, since these must incorporate additional uncertainty. Secondly, it puts a high value on research directed at predicting and exploiting short-term government behavior, and so increases the profitability of speculators at the expense of other types of investors. Even credit decisions must become speculative since, when bankruptcy is a political decision and not an economic outcome, lending decisions are driven not by considerations of economic value but rather by political calculations.
A dramatic example of the impact of government behavior on value investing was China Telecom’s initial public stock offering in November, 2002. The offering was scheduled to come out at a time of weak international demand, and there was some concern that it might not be as successful as hoped. Because the meeting of the 16th Party Congress was taking place in Beijing during that time, a successful transaction would have helped validate government policies and a failure would have been seen as a loss of face. In an attempt to bolster demand the Chinese government pushed through a large and unexpected increase in international interconnection fees, which would result in higher profits for the company.
Instead of boosting demand for the stock, however, this actually had the effect of reducing demand. The deal, originally expected to raise over $3 billion, ended up raising only $1.4 billion, even after being priced at the bottom of the expected price range.
Why was the deal a failure? Much of it had to do, of course, with weak global markets, but the final sudden drop in demand came about largely because by its actions the government made it clear that they would allow non-economic factors to affect the company’s profitability. Value investors, who dominate the large international markets and who would have been the main buyers of China Telecom, felt that their ability to judge the company’s future cashflows had suddenly been damaged. They saw that the company’s profitability depended not just on economic factors, which they are able to judge, but also importantly on political factors, which they cannot. As a consequence they raised their discount rate – that is, they lowered the price at which they were willing to buy shares.
This illustrates one of the main problems facing the development of local capital markets on the mainland. China is attempting to improve the quality of macroeconomic and financial information and is trying to make markets less fragmented and more liquid, but although these are important steps, they are not enough. Value investors need not just good economic and financial information, but also a predictable framework in which to derive reasonable discount rates.
Here China has a problem. It is difficult enough to estimate discount rates in an environment of regulated interest rates and pricing inefficiencies in the market, but in addition, Chinese discount rates must account for excessively high levels of uncertainty. Some of this uncertainty represents normal business uncertainty. This is a necessary component of an economically efficient discount rate, since all projects have to be judged not just on their expected return but also on the riskiness of the outcome.
Discounting risk
But Chinese investors must incorporate two other – economically inefficient – sources of uncertainty. The first is the uncertainty surrounding the quality of economic information. The second is the large variety of non-economic factors – market manipulation, insider behavior, opaque ownership and control structures, the lack of a clear regulatory framework that limits the government’s ability to affect economic decisions – that can influence prices. These factors force investors to incorporate too much additional uncertainty into their discount rates.
This is the important point. It is not just that it is hard to get good economic and financial information in China. Even when good information is available, because of the variety of non-economic factors that affect value the appropriate discount rate is so high that it rarely will lead to a buying decision from a value investor except at a very low price. In China, value investors are essentially priced out of the market.
Speculators however can be much more confident about the information they use and so it is their behavior that drives the market. The consequences are not surprising. Markets in China respond to a very large variety of non-economic information and rarely respond to estimates of economic value.
Under these conditions it is not surprising that the Shanghai market is extremely speculative and that most investors, whether they admit it publicly or not, are largely engaged in speculative behavior. Take most fund managers out for late-night drinks and they will readily admit that the two most useful pieces of information that they crave is information about changes in underlying liquidity conditions and information about which way the government would like to see markets go.
A market driven almost exclusively by speculators, and with little to no participation by fundamental or value investors, is not a market that pays much attention to long-term growth prospects. It is driven largely by fads, technical factors, liquidity shifts, and government signaling.
So what does this year’s crash in the Shanghai stock market tell us? It might be saying something about the impact of the European crisis on export earnings. It might suggest that liquidity in the system is being driven into real estate rather than into stocks. It may reflect contagion and nervousness about the fall of stock markets abroad.
But we should be cautious about reading too much into it. In fact attempts by Beijing to hammer down real estate bubbles in the primary cities without addressing underlying liquidity expansion may simply push asset price bubbles elsewhere, and this could easily cause a surge in the Shanghai stock markets. But this should not then be interpreted as signaling a surge in the economy.
Shanghai’s markets will go up and down, but they are not driven by investor evaluation of long-term growth prospects. China does not yet posses the tools to make such evaluation useful, so be careful about reading too much into the stock market numbers.
So Michael, this raises the question, on what basis (medium term) can you say that the Chinese market will rise? If underlying liquidity and speculative drives are the factors that determine the direction of the stock market (on top of political “interference”) the question that begs to be ask is: Is the Chinese stock market one giant crapshoot? I
BTW always fascinating comments on your part
“Take most fund managers out for late-night drinks and they will readily admit that the two most useful pieces of information that they crave is information about changes in underlying liquidity conditions and information about which way the government would like to see markets go.”
If fund managers are successful in anticipating government’s liquidity policy, then Shanghai stock market should be a good leading indicator for short/medium term economic fluctuations. On the other hand, you are right that high Shanghai stock market valuations are not telling us anything about long term growth prospects.
Mr Pettis
Agreeing with the categorising of investors, only with one doubt – how many “value” or fundamental investors are in today’s context only focussed on the long term, unless you own a great part of the fund or you’re a figure like Buffett, chances are, as a fund manager, here are pressures to keep an eye on the short term bottomline and performance that will ensure you are actually going to be around to reap any benefit from your long term bets. Short-termism has been nuilt into the current system unfortunately.
As for government action being on bases other than economic, erm, isn’t that a feature of most modern day politics. Of course in an ideal world politics won’t be the basis for economic action but most governments are hard pressed to live up to that these days. For example rescue packages that include tax breaks aimed at saving the housing sector are probably not the best way (if only economic concerns were considered) forward, but they are politically “popular”, the same goes for protectionism – whichever side of the great divide you stand on, economically protectionism is hardly the best way forward but whatever plays up to populist sentiments is often the easy way out.
Except for the very (very) few exceptions, most of the investors are speculative with their eyes open, very few are really deluded enough to think that they are in it for the long term or that the mirage is really going to last, the question is can they beat everyone else to the exit before they become fodder.
Though the Shanghai market represents an extreme in its lack of information and transparency,other Asian markets also tend to display this characteristic as well.Except for USA and some countries in Europe, the lack of good informatioin makes it extremely difficult for fundamental investors to deploy money into these markets.The only way to invest in these markets on a long term is through a top down approach using country and region specific ETFs/Funds.
Dear Mr. Pettis,
Good points on the Chinese markets and questionable data but are the US markets really so transparent? Increasingly aggressive Fed interest rate manipulation (short term through Fed funds rates and liquidity operations and long term through quantitative easing a.k.a. money printing), relaxation of accounting standards (e.g. mark-to-market requirements basically waived for several years) and questionable ones (e.g. stock options accounting or pension plans return assumptions), off-balance-sheet liabilities unaccounted for, and so forth. The same applies to US government date e.g. GDP reporting (more and more disconnected from GDI reporting and with 15% of it “phantom” i.e. “owner’s equivalent rent” or “financial services provided for free”), optimistic inflation reporting (underestimated by at least 1% to 2% per year vs. previous reporting methodologies), etc.
I would have agreed with your view of the US markets in the 1950′s and 1960′s but not anymore. The US markets and the Chinese markets are two largely unknowable and unmeasurable quantities nowadays, so any comparison is futile.
Best Regards,
APM
Interesting post Prof. Pettis.
It would seem that the study of Politics in China and government polices is key to understanding a lot of what goes on in the economy. Students of Political-Economy must be delighted. I agree entirely with what you say about people here being more interested in Govt. policy and liquidity (the latter by no means independent from the former). However, i would suggest that whilst not traditional value investors, the role of the government in supporting the market could at least mimic their role. Primarily they seem to be doing this through Central Huijin, (even CIC), the National Pension fund, and the numerous incestual SOE cross holdings of stocks. Do you have any thoughts on this?
Michael,
Stock market is a speculators’ market. Has long term investors effeiciently allocated capital in the West? In other words, can future earnings really be estimated and thus discounted for the long term? I have not seen any. Not even buffet.
Which stock market globally foresaw any crisis or any economic slowdown in advance? I have not seen any. Market top exists only in the hindsight, bubble burst is only witnessed in the hindsight. So, please don’t say S&P or the Dow is of any predicative indicator of actual growth of the economy.
Nowadays, which investors in the west isn’t speculating on what the govt would and would not do? Which market does not move on the change of policy tunes? China is not the exception.
Who said the Shanghai shares is an indicator of nothing? It looks clear to me that it had been a good indicator of policy direction on monetary and housing. Thus, top was formed in late 2009 as monetary policy was changing and again fall off the cliff as property transaction fall off the cliff in April.
The bottom in A shares now also suggest to me that we have seen the end of further property policy, thus A shares will rise from now on.
I think you need to be free of any particular theory of economics as every economist and every theory has been proven wrong by time thus far.
Mike,
Good post as always. I once tried to find financial data for Shanghai listed companies, both A and B shares, and could not find anywhere near the breadth of data in either Chinese or English that exists on the HK exchange or any other modern exchange.
One notable difference is the lack of conference calls or other give-and-take between investors and the company for any Shanghai listed company. Companies listed there seem to only offer the ????, or company report, and don’t give analysts an opportunity to challenge the officers or engage in dialogue. As you mention, corporate governance in China (maybe anywhere?) isn’t at the level where a simple report can be taken at face value without discussion over the contents.
Your mention of Zodiac investing is not far off what does happen in China, where 8 is a lucky number and 4 is unlucky, as you know, and some investors buy/sell based on where they see those numbers playing out.
I’ve always been turned off by trying to seriously invest (versus speculate) in China, but never analyzed why that is so lucidly. Thank you for the post.
Alas, Ben Graham’s weighing machine is broken, but the voting machine seems indestructible in China.
Another good piece, thanks.
I always thought that the reazon why the chinese stock market hardly ever revealed any clue about the chinese economy was due to the poor profit margin of the chinese companies.
After all the stock market is supposed to be a discount cash flow machine even in an enviroment of uncertainty and lack of tranparency.
Judy:
Of course, every investor in every market must deal with government influences. But clearly China is in a class by itself among large economies. Government pervades all aspects of the market. It decides who can buy and sell what, who can lend money, what firm will merge with what other firm, what factories need to be eliminated, what industries are encouraged, etc, etc. Then you have to look at the different levels of government: central, provincial, city, county whose officials often disagree on legal and regulatory interpretation.
Read Shirley Yam’s column from a few months back in the SCMP about business licenses and the retailer who can sell pants but are not allowed to sell belts because those are not mentioned in the store’s business license.
Nice job, Michael. You always say things so much more eloquently than I could.
Interesting post, but the conclusion is way off. Just by looking at the correlation between Shanghai market and S&P, you can clearly tell S&P is a lagged version of SSE in the past 2, 3 years. And guess what, it is China who suffered sooner than US, and of course bounced back sooner too, how can you claim that SSE is predicting nothing? This is weird.
In fact, speculators are market timers and they are the ones who are trying to predict something in shorter terms, not people like Buffet who cares about the long term only (at least he claims that).
Very hard to understand the logic of this post.
Hua Qiao
Not disputing the (very big and not so very invisible) hand of government in China, just saying that in “free” economies, the governments aren’t quite as laissez faire as people like to think. Am not and have never been a spokesman for big government anywhere in the world.
As for licences, was informed by a friend that you need a licence for doing anything in a certain country in western europe, thought he was joking, then realised otherwise. bureaucracy is an unfortunate fact of life we navigate round everyday.
Not much use being allowed to vote but end up not voting because they couldn’t implement crowd control or couldn’t handle the crowds. sigh, if only all the bureaucratic red tape were to magically disappear tomorrow ;p
this is a lot more disturbing but not quite anything new! http://www.spiegel.de/international/business/0,1518,698058,00.html
Judy, I am not sure that most investors are speculative, unless you mean most actively-trading investors, in which case it is true almost by definition. I meet lots of very large institutional investors managing pension funds, insurance companies and even mutual funds, and the kind of questions they ask me suggest they are very interested in getting the long-term economic trends right more than they are trying to get short-term timing right. In markets with excess liquidity and lots of financial distress and event gapping, like now, there is of course a tendency for time horizons to shorten and for investment strategies to become increasingly speculative, and this is almost certainly happening.
APM, I agree with you in part. Historically even the most sophisticated markets veer towards speculative under conditions of great liquidity and great gapping in risk. As I see it this is because both factors tend to raise the relative discount rate for fundamental investment strategies and price them out of the market. We seem to be in such a market now generally.
Houhui, I am not sure the domestic investment strategies of Central Huijin, CIC or any of the other players you mention are based on allocating capital to the greatest economic efficiency, as opposed to fulfilling certain policy objectives. The pension system might one day get there, but much of its investment is determined by government constraints. If these constraints were purely risk management constraints, that would be fine, but I suspect many of them have fiscal policy objectives.
Leon, I would make three points. First, the current crisis notwithstanding, the markets in the US and several other countries have a very good track record of allocating capital with reasonable efficiency, and one has only to see the development of the technology industry over the past two decades to marvel at the ability of financial markets to generate surprisingly good decisions about capital allocation. That is not to say that there aren’t mistakes or periods of highly speculative activity, but this is normally part of the adjustment mechanism towards distortions locked into the earlier cycle. A good system, however, is not necessarily synonymous with a perfect system. Second, I find it a little distressing when people counter observations about china with the argument that it is worse elsewhere. This isn’t meant to be a tit for tat claim. Whether the US allocates capital brilliantly or awfully says absolutely nothing about whether my description of the Chinese stock market is correct or incorrect. Third, I already pointed out that the Shanghai market indicates policy and monetary conditions, and I explained why in the context of my piece that means it indicates nothing. You have completely missed the point.
Jay, I suspect your conclusion may be even more way off then mine, unless you can explain why being a lagging reflection of the S&P is a good indicator of economic value in Chinese companies. Your point makes absolutely no sense at all to me.
You got it backwards. That’s why it doesn’t make sense to you.
Dear Dr. Pettis,
As always, an interesting article, very thought provoking.
As govts intervene (directly and indirectly) in markets more and more, I wonder if the type of behavior you see in Chinese markets may not become the norm throughout the world. Certainly, the last year and half in the US has destoyed my faith that markets are anything other than speculative vehicles. This is primarily because the US govt is taking control of more and more of the economy and we now have GSE’s in many areas of the economy, vice the traditional social policy areas, such as housing and student loans. When major manufacturing sectors, such as autos, are primarily controlled by the govt how can an investor make a rational choice to purchase a competitor that will face competition for cheap funding (i.e. Ford) or lega/regulatory targeting (i.e. Toyota).
Capital markets have been irreparably harmed in the US and I think are only games now for computer algorithms and day traders. I think China is the future of the US (and no, I don’t think that is a good thing).
Thanks again for your analysis and clear writing.
I think in this argumentation, because Michael focuses on China, and because his analysis seemingly goes against the common, if not popular consensus promulgated by the popular media globally, that people fail to see his premise, which is quite simple, the global economy is a system composed of systems. Every economy in the world is a mixed economy, ie….the only fully capitalist state would be a failed state. Every economy, economic system in the world, involves the participation of governments in the economy to varying degrees, some arguably much more than others. Whether it be Japan with MITI in the past or China with its acknowledged manipulation of its market, or every other government with regulations governing one industry or another. Of course the only thing that differs is the nature, purpose and rationale for such interventions. Despite how Michael may be denigrated, I would say misunderstood, by some readers, I believe, despite how his argumentation might go against commonly held belief, that he is truly interested in the general health, and success of the Chinese economy and the global economy. Both his perspectives and insight are crystal clear, if not brilliant if not tempored by his provisios to the opposite, because they are simple, based upon a clear logic, and frankly hard to refute, if the timing for events are sometimes, or have not been exactly correct over the years.
Moving back to government interventions in their domestic economies and the global economy, frankly, global coordinated intervention in the global economy prevented a far more disastrous outcome to recent GLOBAL excesses then would have eventuated otherwise. Now, where further government intervention may come to be necessary to confront a plateauing world economy, where no economy, and the global economy will not see growth like the 2000 to 2008 anamoly, it will only be by further GLOBAL CONSENSUS, and conscessions by those who by traditional economic theory tenants had most benefited during that period of time, as well as other large players in the international economy, to avert the logical consequences of a failure to cooperate. This, as Michael, and others like Rogoff and Reinhart have pointed out, are logical movements with much historical precendent. Where lack of cooperation is the course, there will certainly be movements seen as detrimental by modern economic belief constructs. The fact that investors will eventually put their money somewhere, should be noted, if lessor growth rates, will yield lessor returns over the short to medium terms. With that said, assuming demographic movements in advanced, developing, emerging, and frontier markets globally over the next few decades, it is likely that the global economy would preceed differently by my estimation regardless, with that said, considering population dynamics, and the differing societal needs, in regions and countries globally, it is assured that nations have much to do to increase resource utilization efficiencies to provide a better material existence to their peoples, especially in the areas of food, water, and energy. Where governments intervene in markets to kick start emphasis on creating a system that acknowledges this coming reality, to counter the a growing problem where human expectations meet the need for resource utilization efficiency, water, food, and energy security….all the better. Plus it will definitely be a space for investors to reap loads of money over the medium to long term, a longer term horizon than that to be had at present, if we are to meet the expectations of a growing global middle class, thus the expectations that the rise of China and other players in the global system while safeguarding the standards of living of those who have enabled that rise. Otherwise, despite the fact that I believe there will likely be more governmental intervention in economies globally, such intervention will limit the benefits to all parties without greater global cooperation. China and others would do well to study the implications of de Soto’s Mystery of Capital, and the utility of institution building for safeguarding, and enhancing the lifestyles of their people. People in the West would do well to be more flexible in their understanding of the operations of markets. The enhancement of system institutions are necessary, not because of any shift in economic might from one people to another, but because of the sheer number of participants who have entered into the system which has benefited hundreds of millions, if not billions of people over the last few decades, and which has enabled the rise of many new nations around the globe. But, frankly, it plays better in local presses globally, to play that song in a different chord.
I suspect you are just trying to justifying your previous position (talk the book). SSE leads S&P by about 4 months, why is it not predicting anything? Speculators are predicting policy, but policy is predicting the economy, why is it that the market is not predicting anything? If SSE is not predicting anything, then surely S&P is not predicting anything. Nowadays, super computers are responsible for majority of the tradings in US, why do you think the S&P is a better predictive market than SSE? At the best, you should conclude that stock markets do predict anything (which is more or less correct in my opinion), not only SSE.
Sorry, your post is too far from what I can observe from reality, so it doesn’t make sense. My position may make no sense to you, but it reflects what is happening in the market.
You sure don’t like opposing views I guess. I said SSE leads S&P, and you thought I said SSE lags S&P, very good reflection of your attitude. There is a wide following about this lead in the investing community as a matter of fact, and people are now closely watching the US market since if the lead is indeed valid, then S&P will probably follow suite to enter into a bear market.
Michael,
You point at problems shared by many if not most emerging markets: lack of transparency, lack of participant diversity, etc. China is, in addition the only large market where most issuers are controlled by a government that is, in turn controlled by the communist party. Not a market that gives off conventional signals, but certainly not completely noisy. I guess one looks for quality stockbrokers (ones that know enough to keep you out of trouble and prefereably enough to make you rich). Unfortunately those brokers would be acting irrationally if they gave useful advice to the average client.
So what to make of the information observable from China’s financial markets without having to bribe an insider or walking into an altruistic broker?
Mike,
Interesting leader in the FT over the weekend “Finding a Bolthole in a Risky World.”
http://www.ft.com/cms/s/0/fb57a1fe-7006-11df-8698-00144feabdc0.html
Do you agree that some areas of South America offer better risk-adjusted returns than are available in the West or the East?
Better link at
http://tickerforum.org/akcs-www?post=139112
I agree that these are policy enablers, especially when they operate on the domestic market (which was never in their initial remit). I just saw them as providing a bit of the same “service” as you describe for those stabilizing investors. It seems that several times over the last two years Huijin / CIC have bought in to support a falling market (which probably was undervalued at times) and have reduced exposure when things were picking up. I would tend to think of Huijin and CIC as being a bit more profit motivated than some would think – they still need to service those bonds. There also seems to be a degree of competition between huijin and the MOF with regard to stakes in financial institutions, people i know in institutions part owned by Huijin are normally quick to point out that they are looking mostly for profits.
Mr Pettis:very large institutional investors managing pension funds, insurance companies and even mutual funds, and the kind of questions they ask me suggest they are very interested in getting the long-term economic trends right more than they are trying to get short-term timing right
Not disputing that there are investors that go for the long term view, the question is where they are working for stakeholders that demand a certain return in the short term, chances are they are going to have to meet those demands to “survive” the short term to see out those long term projections.
At the risk of offending some GS alumni, maybe it would not be so wrong to speculate that when the institution began developing a definite turn in its “direction” some time in the 90s (see an insightful article posted by Yves Smith a couple of weeks ago.), it was really playing into the present phenomenon where previously assumed “long term” and “stabilising” investors (such as sovereign funds) now have to combine a long short perspective to meet stakeholder demand.
Huizer:one looks for quality stockbrokers (ones that know enough to keep you out of trouble and prefereably enough to make you rich).
Let me know when you find one :p BTW, nice to see you active again, been a rare sighting!
Jay,
Let me see if I understand you so that I don’t make the mistake professor Pettis is making. You say: 1. The SSE predicts the S&P. 2. The S&P predicts the US economy. 3. The performance of the US economy tells us what to expect in the Chinese economy. 4. And that is why the SSE actually does predict the Chinese economy.
Wow. You have deep faith that Chinese retail investors, who dominate SSE, are more prescient about the US economy than US institutional investors, who dominate S&P, but I am even more impressed by your ability to turn what may be conicidental or explained by many other factors into a powerful sequence of events. This is also opposed to what any investor living in China and nearly every regulator believes. I think it is pretty widely accepted within China that the Chinese stock market mainly prices liquidity and government policies, and not expected changes in future profitability.
Jay, grow up. In your rush to substitute intelligence with snarkiness I think you miss Pettis’s point. You point to a possible correlation between two markets and claim that this implies that Chinese stocks are discounting growth in the Chinese economy. Pettis argues that this can only be true if the S&P is a forward indicator of Chinese economic growth. You are too excited about the mistake that Pettis makes in whether, according to you, one lags or leads the other to notice that it doesn’t matter which leads. The point is that, even if your correlation claim is correct, how does it indicate that Chinese stocks discount Chinese economic growth correctly? There may be many reasons for the correlation that are far more plausible than the dubious claim that S&P is a good forward indicator of Chinese economic growth, and whether you realize it or not, that is the claim you are implictly making.
And professor, i forgot to ask. Why exactly do you think QFIIs have jumped into China if they can’t do there what they do best?
GaryP, I am not so pessimistic as you are. I think that even the most sophisticated markets necessarily go through periods of speculative frenzy for reasons akin to Minsky’s explanation of why banking systems themselves do the same. I also think it is mainly a question of time before the Chinese markets become more sophisticated about allocating capital, but the point of the piece is to suggest that this will have nothing to do with the bells and whistles of approving derivatives, domestic corporate bonds markets, short-selling, QFIIs or anything else. It can only change when the conditions permitting fundamental investment improves.
CSStevens, yes, one of my basic arguments is that when we think about China or any other large player we need to think about systems, and about the constraints imposed by systems. This is a very hard point to convey, apparently.
Jay, I think your arguments have been correctly addressed at least twice by various comments and I agree with TR that you miss the point. You see some weak correlation and get confused about its meaning. The question is whether SSE is discounting future Chinese growth prospects. It almost certainly isn’t, and I don’t see how you have proved otherwise.
Rien, yes, most EMs, and of course most developed markets at some stage – most notoriously the US up to the 1890s or so – have real problems with transparency, governance, and the whole litany of necessary tools for fundamental investment. I think the answer to your question is really one of time horizons. If you want to beat the market over the short term, you really need to be an insider or lucky. Over the longer term you can make reasonable assumptions about Chinese growth and how the benefits from that growth will be distributed, but you still run into big policy problems. For example, who is more likely to benefit from long-term growth, SMEs or SOEs? David Stevenson in the FT discussed something related last week. You can find it at:http://www.ft.com/cms/s/2/1f7a50b8-6ffd-11df-8698-00144feabdc0.html
Rick, thanks. Interesting piece and I think I agree with its thrust.
Houhui, I agree that Huijin/CIC do sometimes act to stabilize markets, but I worry that by their very performance they may undermine credibility in the pricing mechanism, not that there is much to undermine. About your last point, throw in SAFE and PBoC and there is lots of competition among these guys. They often are pretty frank (in private, of course) about their mutual dislikes).
TR, QFIIs have come to China partly because whether or not the markets are fundamentally driven, there are still profit opportunities for fund managers, and partly because they want to be players during the development process so that they can benefit in the future. The initial excitement over what benefits QFIIs would bring to Chinese stock markets has, however, dissipated.
Michael,
This is completely off the topic, but I would appreciate your help with something:
I teach Economics and Accounting at Nanjing University. A few weeks ago, in class, we were discussing matters to do with exchange rates. This was around the time of the media reporting of China’s being a “currency-manipulator” (whatever that means – I believe it has no meaning).
I told the class this:
- that a country must choose between managing its interest-rates or managing its exchange rate but that it can’t (and even shouldn’t) try to manage both;
- that either the floating exchange rate or the floating interest rate is there to take any economic shocks that come along;
- in particular, that there’s no moral dimension to this question and that it follows that China can no more be accused of being a “currency manipulator” than, say, the US Fed be accused of being an “interest-rate manipulator”;
- in conclusion, that the decision to “fix” the exchange rate or else “fix” the cash rate are logically equivalent.
Is my conclusion here correct or not?
I’m asking you only because I don’t know whom else to ask and I thank you in advance for any help you are willing to provide.
Geoff Gibson, Nanjing.
Hi Michael,
Time will tell on your SSE prediction, though your comments a few months back about the US dollar not being at risk of losing its position as the reserve currency for the world and the whole business of SDRs, etc. blowing over once again came true rather quickly. Now that people are more concerned about the continued existence of the Euro I guess the dollar will remain the reserve currency and we can repeat the nail biting in a decade or two. I think just the other day Xinhua reported that Iran shifted some Euro holdings into dollars and gold (though Iran now denies the story, which to me sounds like a confirmation).
Anyhow, since it looks like rebalancing the reserve currencies will not happen, many nations intend to try to drag out the status quo for as long as possible, and you’re in the mood for making timing predictions, care to make any estimates of how long the status quo lasts before macroeconomic stresses become unbearable and major changes occur?
Also, is your argument that not being the sole reserve currency would be better for the US as simple as having multiple large, liquid currencies serving as reserve currencies would reduce US over-consumption and help rebalance the macroeconomy or are there other important nuances that I’m missing?
Geoff in Nanjing, I agree that managing the interest rate and managing the value of the currency can have very similar impacts on domestic demand and domestic production, and so on the trade balance. In highly banked countries like China, reducing the real interest rate has the same aggregate impact as depreciating the currency. – it confiscates household income and uses it to subsidize producers. In principle, in the absence of financial repression, I think you would be right to say that you can control the exchange rate or you can control domestic monetary policy (the interest rate) but not both, but I think this changes in a system like that of China where severe financial repression can reduce the inflationary impacts of the exchange rate policy by reducing household demand, but at the cost of overinvestment and asset and capacity bubbles. This seems exactly what is happening in China. I do plan to write about this at some point. My own thinking on the matter took many leaps forward after Robert Aliber came to speak at my class. You might want to read his stuff.
Matt L, my guess is that China will maintain investment led-growth until at least the change in leadership in 2012, after which time it will be forced to address the debt constraints – inevitably by forcing households to clean up the banks. This is why I think consumption growth will actually slow in the next few years. A lot of people agree with me, which suggests that the market will be shocked if the stimulus is withdrawn before then, so as a trading strategy you might want to be prepared for that possibility. I think the impact of the European crisis will force a rapid rise in the US trade deficit late this year and early next, which, combined with rising US unemployment, will lead to a surge in trade tension by early next year. Watch India. It leads the world in instigating anti-dumping suits against China, and may be a good indicator of the kinds of trade stress the whole world is facing.
As for your second question, yes. Reserve currency status and the flexibility of its financial markets mean that any country seeking to generate employment through export-led growth or seeking to self-insure with rising reserves almost automatically forces a current account deficit on the US as the global balance adjusts. I think reserve currency status has brought some positives for the US economy but a lot more negatives, and I think the US should do all it can to reduce the role of the US dollar as sole reserve currency.
Michael, thanks for your prompt reply. I’ll follow-up on your advice re: Robert Aliber.
By the way, another thing that I told the class (rightly or wrongly) was that China seems to me to be operating without a safety valve: that is, that the currency is, of course, controlled and that monetary policy (aside from changes to the reserve ratio and the occasional nod-and-wink central directive) is ineffective and that, ipso facto, China’s in a particularly weak position to manage shocks.
Geoff Gibson (Nanjing University).
Hi Micheal,
Good, thought provoking post as usual. Only, I’d say India initiates anti dumping duties against China- not instigates. The reasons for this lie in the fact that it has a currency that is convertible on the current account, and an artificially cheaper RMB hurts it’s domestic industry quite a bit. The Indian central bank has given up defending a level of the rupee with its role being limited to stabilizing the currency and ironing out excesive volatility.
Other than that, the Indian industry does not get the kind of “opaque supports” from the government that some industries in China get. Similar arguments will be made by other governments across the world (thereby as rightly pointed out by you- trade tension will escalate).
The flash point in all this will come if liqudity dries up faster than expected. A lot of companies and countries will be found swimming naked, once (if?) the ocean of liquidity dries up. Meaning, entities that are funded by short term debt will be worse off- unable to refinance themselves. The biggest entity funded mostly by short term debt is the US government itself. Hence, one can be assured that the FED will NEVER allow liquidity to dry up… at least till this story is played out.
Only capital surplus countries like Germany and China stand to loose from this flood of liquidity. The rest will happily watch as their debt load gets lighter, erroded by inflation.
Consequently, value investing and speculative investing strategies will lead to investors finding the same sort of companies to invest in!!! Companies that have large revenue streams expected to come online over the next few years, with large debt and beaten down valuations today! These companies will not be able to raise new debt, but they will be able to find enough number of entities to subcribe to their shares funded by cheap debt. Debt masquarading as equity.
The speculative element being, that they will find support from all quarters to ensure their projects or business (infratructure, others where there is real demand and customers) succeed.
So, in this way (even if the above line of thought may not have been fleshed out properly- it does give what I am refering to), in an environment where excessive liquidity and oncoming inflation is destroying value- the Shanghai stock market and markets accross the world may be signalling the death of value investing itself. Inspite of the virtues of good information available in New York and London- it is these markets that will increasingly look like Shanghai- and not the other way round!
This in my opinion is the true cost of the current set of crisis that we’ve been facing for the last couple of years.
Ronnie
Jay,
A market where prices can/are manipulated by insiders who may have uneconomical motives, and where most of the non-insiders are retail investors with a distinctive (compared to the US or other proper markets) set of incentives and opportunities, is unlikely to produce signals that can be explained by outsiders, in the sense that explanations have some sort of meaning wrt future price developments or relationships with other (local or international) economic variables. There may be a very short term (and subject to no change in insider (gvt, SOEs etc) policy momentum effect that can be manipulated by the main insider (the gvt) for any kind of gvt/elite benefit. The analogy is with paticipants in a game of musical chairs where the organizer doe not have to play to reap rewards, determine the entry price, the prizes and the playing consitions, egen during the game. Furthermore, Organizer employees, may for their own benefit or as agents for Organizer, play along with the participants, but with superior information.
Not quite the NYSE
Michael,
What could the U.S. do to reduce the role of the US dollar as sole reserve currency and keep itself from baring the brunt of the trade imbalances?
Hi Michael,
Thank you for the response. I want to make the following obersvation which is very open to your opinion.
I believe the SSE is a good indicator of China’s economic activities and leads the actual economic activities by 3-6 months. Here is why.
The A share housing sector has been a good leading indicator of the overall market and the actually physical transaction volume of properties have been the leading indicator of the A share housing sector. Policy may or may not affect property transaction volume and thus, policies may or may not affect stocks.
For example, vanke A share bottomed exactly when housing trasnaction vol bottomed in Sept 2008 which marks the bottom of the Chinese stock market which led the quick comeback of the economy by a few months. Again, Vanke shares stocked to roll over at the end of 2009 as property market was in a frenzy, the stock market saw the coming crackdown and the subsequent slowdown of transaction vol as well as demand for commodities.
Vanke stock has been one of the best indicator of the real economy by 3-6 months as well as for global commodities prices. ,The close linkage betweeen Vanke share prices and property transaction vol should not be overlooked and the economic fundamentals that enforces this relationship should disprove the argument that SSE is of no economic indicator.
any thots?
Huizer
agreeing with most of what you say. the last line though was a bit ironic. in light of what the “investigation” into Goldman (and other institutions) practices has thrown up, it does indicate the kind of behaviour you outlined. how typical that is of NYSE, well, let’s wait for the potential class action suits to tell us.
Many years ago a gentleman in Hong Kong asked me “Why would you ever buy a stock unless you had inside information?” Interesting question. He also said that Chinese accountants were very good. You have to be to run three sets of books simultaneously.
Went through the Taiwan stock bubble in the late 80′s (somewhat unscathed) where “big hands” were always rumoured to be manipulating prices. It reminds me a lot of how the China market operates now. It does seem to take a fair bit of time (and some crashes) to teach investors a little bit about investing.
Personally I would never tough a Chinese stock because I don’t trust a single number coming out of China (from the government or from a company).
I have a hard time buying many stocks these days because I think people underestimate the impact that technological (and societal) change is having on the validity of “fundamental” estimates. As change picks up, estimates become less accurate ( If I have no idea what many of today’s companies will be selling in 5 years, why should I pay 15 times earnings for the stock) , meaning I should as a fundamental investor be willing to pay far less for shares than in the past (as valued by P/E ratio).
A lot of uncertainty typically leads to lower valuations (as you noted in your example), and these seems to be no let-up in uncertainty or the pace of change.
JUdy,
Everything is relative. US governance and accounting standards, despite all the scandals, are a model for many. Personally I prefer the IAS, but that is because I believe the standard US approach to regulation is generally too formalistic to be effective but it has to be that way because it is embedded in a very adversarial legal system.
Stocks that are majority owned by parties without strong barriers to manipulation by them are more risky than stocks that are more widely distributed and where play is more tightly controlled by rules that benefit the average outsider. From what I know about most Asian markets (includinh my beloved Singapore), stocks with a “majority” free float are rare and opportunities for controlling shareholders, their relatives, friends, employees to outguess the average non-insider are more plentiful than in the typical OECD market. Of course not all these markets are a game of musical chairs, but the PRC market is an unsusually rich combination of elements that handicap the non-insider. As to Goldman, I am not sure what you refer to, but the likes of Goldman would love to participate as a controlling player in the musical chairs game that I tried to descrive, provided they would not be breaking the law. Hence my preference for not too formalistic regulation where the regulators are desinterested and virtuous agents, like in Europe…Maybe
As to Goldman, I am not sure what you refer to, but the likes of Goldman would love to participate as a controlling player in the musical chairs game that I tried to descrive, provided they would not be breaking the law. Hence my preference for not too formalistic regulation where the regulators are desinterested and virtuous agents, like in Europe…Maybe