Not so sure things

February 15, 2007 by  


By Bob Wood

The old stock market adage teaches that ‘’the trend is your friend.’’ But as I have previously explained in this column, not all trends are created equal. Some prove to be far more profitable than others. Only the longer-term, secular trends are worth investing in. And I never said that was easy to do!

The stock markets in China and India are two cases that illustrate this point. There is little argument that both countries are in the spotlight — offering the best short- and long-term growth rates as related to their economies. Both are growing at close to 10%/year and are projected to continue those strong gains for the foreseeable future.

Compare those gains to the comparatively slow-growing, established economies in the U.S. and Europe, both chugging along in low, single digits. And perhaps some of those rather small growth rates could even be questioned, since the expansion of the American economy may be arguably exaggerated by under-reporting of the true rate of inflation. Some, though, such as Economist John Williams, who writes the shadowstats.com web site, are sure that inflation is running much hotter than official figures suggest.

If he is correct, and I think he is, the growth rate of our domestic economy is zero, at best, and may already be in recession territory. One look at the housing market and the announced job layoffs among our largest employers suggests validity for this claim.

Of course, to be fair, we must also question the growth rates of other economies, and using similar inflation rates for other economies helps the comparison. Since economists in India are also concerned with inflation, they are taking steps to address what they admit are inflation rates climbing even higher than the very meager numbers that pass for fact in the U.S.

So now that we have established that much faster growing, healthier economies like China and India exist and invite investments, should we just load up on stocks and mutual funds dedicated to those markets and sit in the shade for the next 10 or 20 years? Oh, if it only were so easy!

Of course, if it were that easy, we’d all be rich from our investing activities. But as anyone who has been involved in the equities markets for any length of time well knows, it’s never easy! At least, it’s not easy for me, since I have to work very hard at this business.

The biggest problem with these investment markets is that the good news about them is already known and well “priced into” their stock markets. In fact, the word has traveled around the world and back home to local investors, many of whom are new to investing. And the signs of strain are becoming obvious.

Each week, I see articles relating how individual investors in China clamor for a piece of the action. Last year’s stunning 130% gain in stocks did not go unnoticed. And similar to what we saw in the U.S. in the late 1990s, when some people were leaving their jobs to become day traders while others were taking home equity loans to fund stock market accounts, those same activities are now apparent in what has been considered a more conservative populace.

Stories are popping up in international media about people in China who have been borrowing money to open stock market trading accounts. If you have ever been tempted to borrow money for stock market investing, allow me to remind you of one very good piece of advice: Don’t do it!

Borrowing money to invest in the stock market is as bad an idea now as it has ever been; in fact, it may be even worse than taking stock tips from CNBC. And this borrowing practice has found its way to China, where, reportedly, investors have been borrowing on credit cards to buy stocks. Obviously, no one has pointed out how significantly they will have to beat the market to justify paying such high rates of interest on their cash stakes.

The Financial Times reported this past week that this borrowing practice has gone beyond all measure of rationality. The manager of a pawn shop in central Shanghai talks about people who are ‘’putting their homes in hock.’’ Yes, it seems that people are borrowing as much money as possible against the value of their homes to invest in the stock market, and that market rose so much last year that a correction certainly can be expected.

‘’This place is kept alive by people pawning their homes,’’ says the manager of one pawn shop, so, apparently, these are not isolated cases. Now I ask you, have you ever seen a better contrarian indicator just screaming ‘’Sell!’’?

To a lesser extent, we see a similar sell signal in the Indian stock market. With the fantastic growth rate in that economy — quoted now as close to 10%, we can easily justify a higher average P/E for stocks. And with its market now quoted as selling at about 20 times earnings, India doesn’t seem all that richly priced.

After all, our Dow now sells at over 20 times trailing earnings, and our growth rate is close to zero. So by comparison, the Indian market looks like a great place to be. But, as reported last week, almost half of all money invested in the eight largest emerging markets went into Indian stocks. And mutual fund flows from American investors last year were sent almost exclusively into foreign stock funds, with over 90% of that money opting for those funds.

In 2005, that figure was over 80%, so for both the Chinese and Indian stock markets, the crowd has been rushing in. And those are reasons enough for my scaling out of both markets. Yet this strategy may be hard to accept if you agree with my philosophy of investing in places with the best long-term prospects for growth.

But my adherence to secular bull market investing isn’t set in stone, and it is not meant to be practiced while ignoring other factors. As Clausewitz pointed out in his book On War, friction occurs in any endeavor involving human impulses. And what stronger impulses are there than fear and greed?

And while I have no doubt that stock markets in China and India will go much higher in another 10 or 20 years and that both still offer better profit potential than our domestic markets, limits exist for any strategy. And those markets have hit my limits.

Of course, you may decide to hold onto your investments in those countries, but I am now opting out of China and scaling out of India, meaning that I still hold positions in that market, though they are getting smaller.

Even the best secular trends will endure periods of disappointing performance, since they often play out in three stages. Between each stage are periods of a few weeks or months when valuations stretch, and then euphoria sets in, clouding investor judgment. And these times appear to be when the two trends are due for a disappointing run.

My best advice is to scale out of these hot markets for now, let the crowd take the brunt of the rough patches — as they always seem to do, and keep your powder dry for a better opportunity to jump back in — when the crowd is bailing out en masse. There are better places to invest in Asia, and, of course, sitting on your cash, waiting for a better entry point, will not be discouraged here.

Another old adage says that our profits come from how much we pay when we buy, rather than how much we make when we sell. Buy at the right times, and prices and profits are much more likely to roll in. Yes, you could wait on the sidelines as long as it takes the crowd to catch on. But once it does, and in such big ways, the best thing you can do is position yourself on the far side of the table and near the doorway out.

Have a great week,
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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