Don't Let China's Stock Market Slump "Decouple" You From its Massive Profit Potential

By Mike Caggeso
Associate Editor

THE PEOPLE'S REPUBLIC OF CHINA: When Asia expert Keith Fitz-Gerald first returned to this country a week ago, he was overwhelmed by a single impression.

"This place is one big construction site," Fitz-Gerald said. "You cannot turn around without finding scaffolding, piles of materials, construction equipment and the like [no matter where you look] here."

With the U.S. economy suffering its worst downturn in years, and China's stocks down more than 40% in the past six months, the bustle of construction-related activity in this Asian giant seems incongruous - if not downright contradictory.

Surprisingly, it's neither. This divergence between China's ailing stock market and its still-spunky economy is an early manifestation of "economic decoupling" - an emerging trend being fueled by the globalization of worldwide markets.

In fact, China's ability to maintain its frenetic growth rate of nearly 11% per annum while the U.S. market could well be mired in a recession is yet another example of economic decoupling, says Fitz-Gerald, the investment director for Money Morning who is currently leading a group of investors on a tour of Mainland China.

"Economic decoupling will continue and is accelerating with each passing day," Fitz-Gerald said in an e-mail interview from China.

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But the main point to remember is that economic strength is a function of consumer power - which China has plenty of, with more still to come - whereas stock markets are a function of expectations.

And the amount of new investors in and outside of China blew expectations too high for companies to deliver, especially in the face of a U.S. slowdown.

"Economic strength and stock markets do not have to move simultaneously. In fact, history suggests they don't. Cycles nearly always reflect underlying economic movement prior to financial markets separating," Fitz-Gerald said.

A Tough Deal

Not everyone agrees with Fitz-Gerald's assessment. The broadest of the three key U.S. stock indices - the Standard & Poor's 500 Index - is down 8.38% in the past six months, although it was down nearly double that before a recent rebound. And the U.S. economy is near - if not actually in - a recession.

Until recently, the U.S. economy was such a key element of the global market that a downturn here made it a near-virtual-certainty that overseas economies would sour and spiral downward - hence the Wall Street adage: "When the U.S. economy sneezes, the rest of the world catches a cold."

Perhaps no longer. Rich in both commodities and cash, China's economy continues to advance. But here's the part that makes decoupling tough to understand: Although the Chinese economy is still growing at a double-digit rate, its benchmark Shanghai Composite Index is down a painful 40.3% in the past six months.

And some of the country's all-star companies have really taken it on the chin. The past six months, for instance:

  • Aluminum Corp. of China Ltd. (ACH) is down 40.65%.
  • iShares FTSE/Xinhua China 25 Index ETF (FXI) is down 22.34%.
  • PetroChina Co. Ltd. (PTR) is down 40.44%.
  • And China Life Insurance Co. Ltd. (LFC) is down 33.75%.

Skeptics of decoupling will argue that China's index is tanking in lockstep with the U.S. economy. However, Fitz-Gerald, who lives in and around Asia, sees a different story both in the numbers and on the ground.

So what gives?

"Most of [the critics of decoupling] are Anglos sitting in the heart of New York City, never having visited and seen this first hand," Fitz-Gerald said. "Economic progress here is unstoppable and market slide is temporary." 

The real answer is that different forces are influencing Chinese stocks and the Chinese economy, meaning the two aren't always as interlocked as people would like to think.

For a long time, most China stocks were off-limits to foreigners, and even domestic investors faced restrictions on where they could put their cash. As an increasing number of China-based companies went public and made their shares available to both domestic and foreign investors, cash poured into those firms, running their shares up much higher than the company's underlying value really warranted.

"There is so much capital chasing them that it's natural they're going to move," Fitz-Gerald said.

Granted, some investors who knew when to cash in and pull out made quick fortunes.

But many first-time investors (or first-time China investors) bought Chinese stocks blindly, lost a ton of money, and are now scratching their heads wondering why investment analysts keep talking about China's vast investment potential.

The major culprits that dragged down China's indices are stock market linkages between the United States and foreign markets - meaning that currency devaluations and slowing foreign economies (such as China's major trading partner, the United States) pinched the profits of some Chinese companies - but nowhere near enough to cause a downturn there.

Plus, unlike past emerging-market downturns, there hasn't been massive "capital flight," with foreigners taking their money and heading for the safety of their banks at home. China has too much long-term profit potential for foreign investors to give up now.

Besides, even if they did, China has record foreign reserves of $1.68 trillion - more than enough to weather a rainy day in the economy there.

On top of sightseeing, shopping, food, and hospitality well beyond the standard tourist fare, Fitz-Gerald is leading a tour of one or more of China's stock exchanges. [Fitz-Gerald is also the editor of the New China Trader, an investment newsletter dedicated solely to finding value and profits in China's red-hot economy].

And although it's difficult for investors to navigate through the volatile markets, the long-term payoff is worth the pain.

The bottom line is that China is on track for 10% to 12% growth this year - and that's after China's government has taken steps to slow the country's economy down.

"Investors who abandon China now will live to regret their decision," he said. "Even if the U.S. economy skids into a recession, China will continue to grow for decades to come. And that's after nearly 30 years of double-digit growth that country has already logged into the history books.

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