China Is not the Problem

Maybe it’s time to dig out Charles Mackay's famous, "Extraordinary Popular Delusions and the Madness of Crowds,” published in 1851, the quintessential book on financial bubbles and the inability of overeager investors to resist them. After all, the Shanghai share market has risen by 60 percent in the first half of 2007 after an increase of 130 percent over the last year, prompting some people to pawn their houses to get the money to stuff into stockbrokers’ pockets, according to the Financial Times.

Things have got so far out of hand that Alan Greenspan, the former Federal Reserve Chairman in a June video sent to participants in a management conference in Madrid, warned that “At any moment, there is going to be a dramatic contraction.” In the video, he said the Chinese market’s run up was “clearly unsustainable,” and added that a correction could damage living standards and tempt the country to use its US$1 trillion in reserves to bail out investors. Moreover, Greenspan said, given that imports from China have played a major role in powering global growth, it could endanger world markets as well. “This cannot continue, and it is not going to continue because this adjustment is too rapid,” he said.

But it isn’t the Chinese market that Greenspan ought to be worried about. Last Thursday and Friday, the Dow Jones Index of 100 industrials, ignoring any cautionary tremors in the credit markets, took off again into record territory, gaining 2.2 percent over the week and closing at 13,907.

At least China has a torrid economy to back its stock market. According to the People’s Bank of China, the country’s economy is expected to grow 10.8 percent in 2007, the fastest rate in more than a decade, while the consumer price index will rise 3.2 percent, the central bank's research bureau said in a report published Friday. It would be the fifth straight year that China's growth has topped 10 percent, against a cost of living increase of about 2.5 percent.

Contrast that to the United States, where real gross domestic product grew just 0.7 percent in the first quarter of 2007, according to the US Treasury Department, and 1.9 percent over the last four quarters. Consumer spending, which drives the US market, rose at an anemic 2.5 percent over the year ending in the first quarter. Inflation is relatively tame at 1.9 percent annually, although headline inflation, the rate at which the cost of living is rising, is increasing at 2.2 percent, which is above Fed targets.

Nonetheless, the Dow closed at a record 29 times in the first six months of 2007 as investors went on their own rampage. Takeover speculation and share buyback activity, particularly in mining, metals and energy, hit Alcoa, inc., which led the Dow last week on reports it was a takeover target. ConocoPhilips, the energy company, announced it planned to buy back US$15 billion in shares, part of US$49 billion in buybacks announced last week. Google and Apple, the two darlings of the tech world, both hit all-time highs Friday

Yet, on the same day these headlines appeared in major US media:

  • “Treasuries Rise on Subprime Crisis, Outlook for U.S. Economy.” – Bloomberg

  • "US Trade Deficit Widened 2.3% in May to $60 billion" – Bloomberg.

  • "Realtors cut home sales, price forecasts again" - Reuters

  • "US foreclosures jump 87% as lending practices tighten" Bloomberg

  • "S&P cuts $6.9 billion in mortgage backed securities" CBS/Marketwatch

  • "Margin debt hits record $353 billion on NYSE" Wall Street Journal

  • “Dollar Drops to Record Low Versus Euro on U.S. Growth, Rates” – Bloomberg

  • “Brent Crude Hits Fresh 11-Month High – Financial Times

And finally: "Fox to start business channel broadcasts October 15" CBS News.

The latter headline seems almost guaranteed to bring the process to a halt. It was either John D Rockefeller or Joseph Kennedy, or maybe both according to what may have been an apocryphal story, who reportedly got out of the market in 1928 after a shoeshine boy offered a stock tip. If shoeshine boys were delivering stock tips, Rockefeller (or Kennedy) reasoned, it was time for professionals to run for cover.

”Fear and greed are what drives the market over the short term, but earnings and dividends ultimately matter,” Anthony Conroy, managing director at BNYConvergEx was quoted as saying last week. The market, Conroy said, has broken its recent shackles, and investors who are not positioned for the move now face having to buy back stocks, which could push the market higher yet.

It is questionable what tools the US Federal Reserve Chairman Ben Bernanke has to combat any of those headlines. If he raises interest rates to combat the fall in the US dollar against other world currencies, particularly the euro, which has risen to more than 1.38 against the greenback, he risks stifling the already faltering US economy. Currency markets are betting that Bernanke can’t cut interest rates because of his concerns about inflation. If the dollar falls more steeply against foreign currencies, the price of imports will skyrocket, adding to concerns about inflation.

Those concerns extend to the vast mountain of private equity debt held by buyout firms, which could well top US$500 billion in 2007 – compared to less than US$20 billion in 1991. Any significant rise in interest rates would put those buyout firms at risk – along with the increasingly desperate subprime housing market in the US, whose troubles have been reported extensively.

Maybe the bull market has three months to run and Fox’s business channel will get on the air before investors opt for old movies and sports, as they did in 2000 when all-business channels lost vast numbers of readers who lost their appetite for stock tips from television announcers and shoeshine boys. It might be wise to heed the advice of a US Army field first sergeant in a long-ago war who, when artillery shells from his own unit began to spatter the hills around him, said, “Maybe we ought to dig a little hole, here…”

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