Selling the Pao Mo

"You make money by buying something when nobody else wants it…and selling when everyone wants it." Way out in front of the crowd, Dr. Steve Sjuggerud says now is the time to sell China’s Pao Mo*.

*"Pao Mo" = "Bubble" in Chinese

– A waiter pulls my friend Porter Stansberry aside. "Psst…I overheard you talking about China…how can I get in?"

– A champion professional windsurfer (and friend) tells me, "I want to invest in China."

– Two China IPOs debut in the U.S. (Linktone and Tom Online)…and both of them fizzle quickly.

– Shares of PetroChina soar on huge volume after having done absolutely nothing for many years. (The only real news was that Warren Buffett bought some.) After an enormous rise, both share price and the activity in the shares fizzle.

– Friend and journalist Andy Carpenter makes the cover of the Wall Street Journal section on investing for the successful launch of his "China Club," focusing primarily on small, China-related stocks. Andy honestly tells the WSJ reporter he hasn’t been to China and has little China experience. "Don’t look for me to give you a grand insight into China…My opinion is as good as anyone else’s."

…They say they don’t ring a bell at the top of the market to let you know when to get out. No, they don’t. Yet to me, all five of these things above are the proverbial bell – very real indications that the boom in China-related stocks has peaked.

You know we’re at the peak when the waiters and windsurfers want in and "China Clubs" pop up. And you know it’s running out of gas when you see the January peak in PetroChina and the two failed China IPOs.

Sell Chinese Stocks: Not Voting Against China

I expect China-related shares to fall dramatically. Here’s a piece of advice for you: if you own any China-related stocks, sell them now.

Don’t get me wrong. I see what’s happening in China. Of course I know that the economy is growing. And of course I know that China has completely changed the landscape in commodities, as its demand for raw materials seems insatiable.

So let me be clear – I am not "voting" against China. I am simply voting against China stocks. They’ve simply run too far, too fast. Everyone, including waiters and windsurfers, want in.

To me, that means it’s time to sell.

Yet a huge pile of "hot" money has been flying into China. Which reminds me of something John Train wrote in one of his Money Masters books. It went something like, "You should ask yourself: Where is my money needed so badly that I can really get paid for sharing it if I can stand some risk and discomfort?"

I have remembered this phrase, and I’ve invested successfully based on it. Nobody, for instance, was investing in Iceland when I first wrote about it a few years ago. Nobody was buying Ecuador when I first wrote about it in 2000 (I wrote a few cover stories for the Oxford Club newsletter on buying Ecuador back then), and the Ecuador stock market rose by triple-digits in dollar terms in 2000 and 2001.

Let me share a fact with you. At the end of January, the governments of China and Hong Kong together held a total of over $200 billion U.S. dollars in cash and U.S. Treasuries. Now, since China is directed by its government, let me ask you: Is your money needed badly in China right now?

Sell Chinese Stocks: Time to Get Paid

Absolutely not. So the chance for you to really get paid in China right now is very low.

Just take a look at what has happened in previous "China manias." We don’t have a decent history of stocks in China to draw from, but the next best thing is Hong Kong. Over the last 20 years, every time the P/E ratio of the Hang Seng Index (Hong Kong’s version of the Dow) reached 20, Hong Kong stocks lost between a third and half of their value.

It happened in late 1987, and the index fell from around 4,000 to around 2,000 – a 50% fall.

It happened in January of 1994, and the index fell from around 12,000 to around 8,000 – a 33% fall.

It happened during the dot-com boom in 2000, and the market fell from around 16,000 to around 9,000, nearly a 50% fall.

Can you believe that it’s happened again already? Yes, last month, the P/E of the Hong Kong stock market rose above 20. Time to sell.

China in 2004 really is like the Nasdaq in 1999. The waiters and the windsurfers are expecting astronomical returns. But they – and most investors – don’t have a clue about what it is they’re buying…and they’ll likely end up disappointed.

You may have lost money in the Nasdaq bust of 2000. Don’t get burned a second time.

Regards,

Steve Sjugerrud,
for the Daily Reckoning
March 25, 2004

P.S. You don’t make money buying what everyone wants. You make money by buying something when nobody else wants it…and selling when everyone wants it. I call it "Hold your nose and buy" investing…quite often, the more "stinky" an investment sounds, the greater its potential for profit.

Consider this…the list below is all the countries whose stock markets have risen by more than 100% total in U.S. dollar terms over the last five years. There are only six markets, and they’re all in "stinky" places…

1. Russia
2. Pakistan
3. Czech Republic
4. Venezuela
5. Hungary
6. Indonesia

Meanwhile, if you had invested in the "safe" countries, you’d have lost money – for the last five years! Only a few markets in the world are down by 20% or more over the last 5 years…and many of them are in "pleasant-smelling" places:

The Nasdaq (down 20%)
England (down 20%)
Japan (down 23%)

In my experience, what appears most desirable is often the riskiest place for your money…and what appears risky is often an extraordinary opportunity.

Everyone wants to get in on China right now. That’s why I think it’s time to get out.

Editor’s Note: Dr. Steve Sjuggerud has worked in the investment world as a stockbroker, the vice president of a $50 million global mutual fund, an international hedge fund manager, and the director of several research departments. An international currency and emerging markets expert, he is the editor of the True Wealth monthly advisory.

Nothing happened again yesterday. The Dow went up…or down, we can’t remember. Gold, up on Tuesday, went down on Wednesday. It remains at about $417 – more than $20 more than it was 2 weeks ago.

The dollar also went up and down…with no clear trend or calamity in sight.

Most often, that is what happens – nothing.

But we remind readers that betting on nothing is not always a good wager. The average person is almost incapable of imagining that anything could happen. He puts his money on nothing – sure that what happened yesterday will happen again tomorrow, nothing more, nothing less. Prices are always prejudiced in favor of nothing; investors’ emotional momentum carries them only in a straight line…from yesterday, through today and on to tomorrow…with nothing ever happening but more of the same. At the end of a long bear market, prices are too low…because investors expect them to continue going down. At the end of a long bull market, prices are too high…

But after a long period when people have come to expect nothing but ‘more of the same,’ ‘more of the same’ becomes overbought. People bet on it. They come to depend on it. When interest rates go down for years, for example, they begin to imagine that credit will always be cheap and easy to get. When house prices seem to do nothing but go up…they buy a bigger house than they can afford…counting on low rates and capital gains to bail them out.

"Stability breeds instability," said economist Hyman Minsky. People are reluctant to lend money when the future seems dangerous. ‘Something might happen,’ they say to themselves. But when nothing happens for a long enough time…they gain confidence. Both lenders and borrowers figure they can ‘put the money to work’ and be better off. They put additions on their houses, buy new cars, and pick up a few tech stocks; the economy booms.

When nothing happens for a long, long time…people begin to think nothing will ever happen. An investor who bets that something WILL happen will be wrong almost every day. His friends will make fun of him…and he will lose a little money. He could have gone into tech stocks along with everyone else. He could have bought a bigger house and taken the equity out. He could have borrowed more, spent more, and lived higher on the hog.

But the man will have his revenge. The odds are with him. He will still be wrong on most days…but then, one day, SOMETHING will happen.

Something began in January of 2000. Stocks fell. A recession began a year later. But so great was the official campaign to prevent something from happening – so much new money and credit were brought into the economy to keep people borrowing and spending as they had before – that whatever was happening seemed to stop happening. "Nothing has changed," said investors. "It’s still the same," said consumers. "Party on," said Alan "Bubbles" Greenspan.

This week’s news brings nothing to contradict them. Home sales are rising. Mortgage refinancings are increasing. An advertisement popped up on our screen telling us that "The Refi Boom is NOT Over…Here’s how to lower your payments!"

So great is the pressure to throw away money that the art world is running out of things to sell in the galleries, according to a report in the NY Post (more below…). Meanwhile, the NYTimes tells us that swindlers (called ‘phisters’) are working overtime on the Internet.

Nothing seems different. Still, last week…or was it the week before…it looked as though something was starting to happen again.

Rumor had it that Mr. Mizoguchi, Japan’s leading monetary strategist, had had enough of lending money to the U.S. He denied the rumor…but people still wonder.

And now we see stock markets all over the world seeming to top out.

"This morning I looked over maybe a hundred charts," wrote Richard Russell yesterday, "and what I see is a worldwide movement OUT of equities. Everywhere I look, I see tops – huge tops, medium-sized tops, small tops, even smaller tops. What these charts tell me is that U.S. and global investors are moving out of equities." There is no great concern in the financial press – at least not yet. No panic. For the moment, no one seems to have noticed. But something was bound to happen sooner or later. Now is as good a time as any.

Here’s Eric with more news:

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Eric Fry in New York City…

– The dollar rocketed higher yesterday, but the stock market merely muddled along. The resurgent greenback gained 1.6% against the euro yesterday to $1.2133, as rumors swirled that the European Central bank would soon begin lowering interest rates on the Continent.

– But the stock market – refusing to follow the dollar’s lead – wandered all day like a lost child. The Dow strayed 15 points below Tuesday’s closing price to 10,048, while the Nasdaq crept ahead 8 points to 1,909.

– If Wall Street really wants to get serious about sparking a powerful new bull market, the solution is simple: Provide zero-percent financing for all tech stock purchases. Imagine the marketing slogans:

"Don’t just keep up with the Joneses…Kick their butts!"…"Load up on tech stocks with no money down!"…"Zero percent financing for life!"

– As it is, the stock market is gliding aloft on the thermal draft of easy money. Indeed, easy money is billowing into every nook and cranny of this vast economy of ours, inflating the disposable incomes of Mr. and Mrs. Consumer…And the spendthrift couple is wasting no time disposing of its income. Nor are these two folks hesitating to dispose of their colossal borrowings as well.

– Disposal is not necessarily the best use of one’s cash, especially when the economy is refusing to add jobs or increase wages. But don’t tell that to consumers or lenders or the Federal Reserve chairman. These folks all understand that borrowing and spending is what makes America great. Don’t we Americans owe more money to more people than any other country in the world? And don’t we also possess the world’s number-one economy?…Case closed.

– Furthermore, if we consumers didn’t borrow, we wouldn’t have any money to spend, and if we didn’t have any money to spend, we’d be poor, right?

– Problem is, we are not only running out of savings, we are also running out of equity in our houses. Fortunately, we are NOT running out of ways to borrow against the last slivers of our – present and future – home equity. Fear not, unconventional mortgages are riding to the rescue…

– "Lenders are coming up with increasingly creative mortgages aimed at owners whose budgets are stretched thin," the Wall Street Journal reports. "Lenders such as Countrywide Financial Corp. are offering mortgages that allow some borrowers to skip up to 10 payments over the life of the loan. The rise of these oddball mortgages comes at a time when sky-high home prices are making it tougher for many borrowers to afford their dream house – or any house…

– "Already, some loans that seemed novel just a year or two ago have become almost mainstream. One example: interest-only mortgages, which allow borrowers to pay interest and no principal in the early years of the loan…"

– And along comes Washington Mutual to help indebted homeowners, like a bartender helps alcoholics. The big mortgage lender now offers an adjustable-rate mortgage with an interest-only feature. "It calls this mortgage Option-ARM," reports Grant’s Interest Rate Observer.

– "In just one year," continues Grant’s, "the percentage of WAMU’s customers selecting Option-ARMs has leapt to 40% from 5%, according to Harry Tomlinson, senior vice president for the Northeast region….The borrower can elect to go interest-only and make no amortization payment. Tomlinson explains: ‘If you have a little bit of financial challenges, you can always have the option of deferred amortization, but you don’t have to. That’s a choice. What I see is a shift in the mortgage product, going from our product used by one’s home…to a product where people can leverage their home as a financial asset, and that’s a big shift.’"

– Indeed. But once the happy homeowner has finished "leveraging" his "financial asset," he finds himself the proud owner of a "financial liability"…and that’s not very much fun.

– "When the Fed lifted the funds rate in 1994," Grant’s recalls, "it caught out the hedge funds and interest-rate speculators. When it raises the funds rate next time, it will catch out Mr. and Mrs. America."

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Bill Bonner, back in Paris…

*** Paintings and other art treasures are fetching record prices. A 1917 nude by Modigliani, for example, went for $27 million. Which reminds us of the time when the Japanese were at the top of their bubble – spending millions for Western works of art. The Japanese, we recall, favored the impressionists; they figured the lightweight dabblers went better with modern office décor. Rich Americans tend to squander their money on more serious and less appealing works.

But Sotheby’s and Christie’s sales are down. The auction houses say they cannot get enough inventory to keep up with demand.

A reproduction of Modigliani’s famous oeuvre would be bad enough. But at least it would be cheap. What charm the real thing has, we cannot tell you. But perhaps it is a great investment. Everyone knows it is a great painting – why, someone paid $27 million for it! And everyone knows that great works of art only go up in value.

(We attended an art auction at Drouot’s the other day. We got carried away and bought a lovely little painting of apple trees. But we paid too much – at $350, we felt we had been robbed.)

It must all be part of God’s plan, we imagine. And what a marvelous little machine it is: a man makes a little money…and then, up surge a host of ways for him to get rid of it.

He can be perfectly happy with red wine in plastic containers, for example, finding the no-drip spigot a handy innovation. But then, as his wealth increases, everybody encourages him to spend more money on ‘better’ wine – which he has to open with a bloody corkscrew! He resists at first, but then come the many reasons why the ‘better’ wine is richer, subtler, more nuanced…and so forth…and pretty soon, people are congratulating him for his sophisticated taste…and he’s actually beginning to take the whole thing seriously himself…studying the wine list as if he knew what he were doing…and choosing a ’96 rather than a ’97 because he read somewhere that it was rather cloudy in the Bordeaux region in the summer of ’96 and someone told him that it took a little of the edge off the wines from the south-sloping fields in Pomerol.

*** The newspapers are full of grand plans for democracy. Building democracies here. Protecting democracies there. Strengthening, perfecting, nurturing democracies everywhere – the big thinkers, kvetchers and world-improvers can’t seem to think of anything other than how to breed and export what they call ‘democracy.’

But why? They do not explain. What is democracy? Why is it better? In the Soviet Union people voted. They voted in Hitler’s Germany and Mussolini’s Italy (at least, for a while). They voted for WWI…and WWII…They voted for the Vietnam war in America…and the Gulf wars…Almost everywhere, they seem to vote for higher taxes, more government, more weapons, more war, more debt and less freedom – because these were the major trends of the most ‘democratic’ century in history.

Dan Denning sends a reflection:

"Two consecutive elections…[Spain, Taiwan]…two acts of violence. Who says elections are won by campaigning? Maybe we’ve entered the age where they’re won by skillful manipulation of the democratic masses at the voting booth, maybe through violence, like firing a starting pistol to get the herd headed in the direction you want.

"[Robert] Prechter asked but never answered the question yesterday: ‘Do you think the world will be more democratic in 50 years, or less?’

"My prediction: more democratic, less free."

*** While the Japanese were still spending millions to buy paintings of flowers…the future president of the U.S. was sweating bankruptcy.

Here’s an unsolicited email:

"At a May 1990 meeting [of Harken Oil] attended by George W. Bush, board members discussed a stock offering they hoped would bring in enough money to keep the company solvent.

"Bush was named to the board’s ‘Fairness Committee,’ which was to measure the effects of bankruptcy on small stockholders. By late May 1990, internal memos warned that there was no source of immediate financing, loans were slipping out of compliance, banks were demanding guarantees of sufficient equity to cover loans.

"As Chairman of the audit committee actually working with the accounting consultants called in by the board, Bush knew exactly how grim their conclusions were. He was warned, along with other directors, in a May 25 memo that it would be illegal to dump his stock. In June he left the small stockholders holding the bag. He dumped $848,560 of the stock without disclosing the sale to the SEC.

"On Aug 22 Harken’s second quarter report predicted $23 million in losses. Once the news hit the street, the stock sank immediately from $4 to $2.57. It bottomed out at 22 cents a share.

"So Martha Stewart is on trial and George Bush is President."