Mark Hulbert does a great job of explaining how sentiment works
in bull and bear markets. He has examined market statistics and
investment newsletter writers for the same 31 years that I have
been in the investment business. His analysis shows that bull
markets climb a wall of worry and that bear markets decline on
stubborn bullishness. Investors buy the dips in bear markets and
become more committed all the way down. It reminds me of the main
characters in the movie, "Dumb and Dumber." Lloyd Christmas (Played
by Jim Carrey) and Harry Dunne (Played by Jeff Daniels) seemed to
compound their mistakes in every pursuit they undertook.
What brought this to mind is the price action of the last week
in the U.S. stock market. Stocks have rebounded sharply from the
lows of Monday, October 3rd. The rebound has been led by Energy and
Basic Materials stocks like Apache (
), Joy Global (
), Freeport McMoran Copper and Gold (
), Schlumberger (
) and Caterpillar (
). These have been the heart and soul of the BRIC trade for the
last 5 to 10 years. The theory is that the growth in China and
India will cause immense demand for energy and basic materials.
This in turn causes Brazil and Russia to prosper by providing China
and India with the energy and basic materials they need. They are
not in the BRIC acronym, but you can throw Australia and Canada
into that mix.
If you read David Barboza's columns in the New York Times,
you'll see that a major credit crunch in China is causing all hell
to break loose in the world of small to medium size businesses.
They are the entrepreneurs in China and they have not received
loans from the four largest banks in China which are government
owned. The Chinese government's dictated lending spree of the last
three years went to communist party officials at the municipal
level, who formed special purpose vehicles to develop condo, office
building and other infrastructure projects. Instead, a massive
underground lending system has developed where risk takers with
cash have sought higher interest rates than the
government-controlled banks offer. This money was loaned to
businessmen and developers who couldn't get the cheap financing
offered by the government. The borrowers wanted these loans to ride
the boom. These small to medium-size businesses operate on fairly
thin margins and the slowdown in the world economy of the last six
months, triggered by supply chain problems in Japan, has put many
of them over the edge.
Thousands of Chinese business owners are disappearing and
walking away from their business because they can't meet the
demands of the high interest rates and the underground loans they
have taken to fund their business. Here is how David Barboza
describes the situation in his October 13th piece called, "As
China's Economy Cools, Loan Sharks Come Knocking":
WENZHOU, China - The 300 employees of Aomi Fluid
Equipment here were delighted recently when the owner offered
an all-expenses-paid, two-day trip to a mountain resort three
The owner, Sun Fucai - or Boss Sun, as he's known - was
so insistent that his workers attend that he imposed a $30
fine on any employee who refused the getaway. Nearly everyone
Except Boss Sun.
When the employees returned from their holiday, they
found that the factory had been stripped of its equipment and
that Boss Sun had fled town. "It was entirely empty," Li
Heying, a former Aomi worker, said of the factory. "It was
like what happens in wartime."
The boss, as it turned out, was millions of dollars in
debt to loan sharks - underground lenders of the sort that
many private businesses in China routinely use because the
government-run banks typically lend only to big state-run
As China's economy has begun to slow slightly, more and
more entrepreneurs are finding themselves in Mr. Sun's
straits - unable to meet debt payments on which interest
rates often run as high as 70 percent in this nation's
thriving unregulated, underground loan system. Such illegal
lending amounts to about $630 billion a year, or the
equivalent of about 10 percent of China's gross domestic
product, according to estimates by the investment bank
A major credit crunch for businesses is now occurring in China.
Its economy, which was built on its businesses having a significant
cost advantage over other competitors around the world, is losing
its advantage to inflation. As that advantage dissipated over the
last five years, China chose to go on the world's biggest building
spree. In the process, they have made fixed asset investment an
unrepeatable 50-70% of the GDP of the second largest economy in the
world, depending on whose estimates you use. Real estate
transactions and development is estimated to be 74% of municipal
In other words, if China doesn't keep on building at the same
pace as the last three years, their economy will contract.
Therefore, the two-pronged economy of China, exports and
infrastructure construction, are both threatened at the same time.
Exports are threatened by the underground markets ability to
over-leverage small to medium sized businesses and the construction
world is over-leveraged on cheap money force-fed into an economy
that doesn't need what is being built. There is nobody to rent the
condos and too few citizens who can afford a train ticket.
This brings us back to the U.S. Most of the U.S. economy's
recovery has been held hostage by incredibly high commodity prices.
We have had the worst and deepest recession since 1981 and the
deepest depression in construction since the 1930's. On a per
capita basis, home building is at 70-year lows! This means that
demand for copper, steel, iron ore, cement, coal and oil are way
down from four years ago. We are using the least amount of gasoline
since 2000 and the least oil since 1996.
We have been struggling to recover against a back drop that
includes record high input prices. At the same time, energy costs
and demand for food in China and India have made Americans pay much
higher prices for food and other goods. All of these facts stem
from the demand coming from China and the faith that has been
placed in the idea that their economy is not subject to normal
business cycles. David Barboza's article is proving them wrong:
"That tycoons in a city known for its savvy entrepreneurs
are running scared has raised concerns that private business,
a vibrant part of China's economy, may be losing steam -
while exposing the high-risk, unregulated financial system on
which so many of the nation's small and medium-size
businesses have come to depend.
"There have always been people running away because they
couldn't pay their debts," said Wang Yuecai, general manager
at Wenzhou Yinfeng Investment & Guarantee, which
guarantees state bank loans when small businesses are lucky
enough to get them. "But recently, the situation here has
gotten much worse."
Last week, Prime Minister Wen Jiabao and a delegation of
top officials, including the head of the nation's central
bank, visited Wenzhou, promising to get official banks to
lend more to small companies and to crack down on underground
lenders that charge high interest rates.
And on Wednesday, China's state council, or cabinet,
announced a series of measures aimed at helping small
businesses with tax breaks and new lines of credit.
Beijing no doubt worries that similar problems could
surface in other parts of the country.
"This is not just happening in Wenzhou," said Chang Chun,
who teaches at the Shanghai Advanced Institute of Finance.
"Some companies borrow from the state banks and then lend
into the underground market. Many are doing this type of
Thanks to research done by Kynikos Associates LP and its
founder, Jim Chanos, we believe that many of the premises used to
create faith in the idea that China's economy won't suffer normal
business cycles is unfounded. For example, many China apologists
argue that 25-30 million people will move each year to the cities
from rural areas and support the added infrastructure. I don't know
how to say, "If they build it, they will come" in Chinese, but that
is the theory. Chanos argues that Kynikos research found 8.5
million people migrated in 2009 and a total of 118.7 million since
1998. However, all that movement is predicated on jobs being
available in the cities and that is predicated on the building boom
continuing along with those entrepreneurial businesses surviving.
It sounds so much like the retiree migration that was anticipated
in Miami, Phoenix and Las Vegas in 2005 and we all know how that
myth worked out.
Michael Pettis has provided us statistics that which show what
an unusually large part of the world's commodities have been used
in China in recent years. This was backed up this week by a report
which puts China as having 1.9 million metric tons of copper
stockpiled at the end of 2010. This is equal to all the copper used
each year in America. The credit crunch for small to medium sized
manufacturers included them using copper as collateral for
We have argued for three years that commodities are ridiculously
over-priced and have argued that China has to have a deep
recession/depression if it wants to become a major and sustainable
world economic power. We believe this is all unfolding before our
eyes, yet U.S. hedge fund, institutional and individual investors
are buying every dip in the commodity markets and playing the same
risk-on trade that worked in 2009. Hulbert would say that their
dogged bullishness is a bad sign for contrarians.
Wenzhou is one of China's many manufacturing metro areas.
Barboza relied on research from Wang Tao, a UBS economist based in
Hong Kong. Here is how Tao and Barboza show the current
"As long as China's economy was racing along at an 11
percent growth rate, small companies could hope for enough
business to stay a step or two ahead of their underground
creditors. But there was little room for error.
Now, businesses here and elsewhere in China are being
caught short because the national economy has begun to
moderate a bit, to a projected 9 percent rate by year's end,
in response to government-imposed measures to fight inflation
and let air out of the real estate bubble.
Ms. Wang, at UBS, said the slowing economy and weakening
exports would hurt many small Chinese businesses. Already,
according to a recent survey by the city's small-business
council, one in five of Wenzhou's 360,000 small and
medium-size businesses have recently stopped operating
because of cash shortages."
This means that 72,000 businesses have recently been shut down
in just one city in China. A major credit crisis and
recession/depression is in the offing, in our opinion. Yet U.S.
investors continue to pursue the BRIC trade all the way down. This
is why the investor behavior reminds me of the movie, "Dumb and
Dumber." We believe the next great bull market in U.S. stocks will
not be led by the best performing sectors of the last ten years,
because leadership in energy, basic materials and heavy industrial
can only come from uninterrupted growth in China. If China can
continue its charade, we believe the U.S. economy will continue to
suffer. If not, the seeds of U.S. prosperity will be watered and
fertilized by lower commodity prices.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
The information contained in this missive represents SCM's
opinions, and should not be construed as personalized or
individualized investment advice. Past performance is no guarantee
of future results. Some of the securities identified and described
in this missive are a sample of issuers being currently recommended
for suitable clients as of the date of this missive and do not
represent all of the securities purchased or recommended for our
clients. It should not be assumed that investing in these
securities was or will be profitable. A list of all recommendations
made by Smead Capital Management with in the past twelve month
period is available upon request.
Don't Be Afraid Of The Service Sector