Red-hot China may burn long-term investors «

    Red-hot China may burn long-term investors

    After the Communist Party’s Central Committee meeting ended, China has issued a 20,000-word document discussing reforms. The document contains 60 items, and plans for results to be achieved by 2020. But what do they mean for investors? And how was the news taken?

    Investors are euphoric. Overnight on Monday, Hong Kong-listed Chinese H shares gained 5.7% building on a 3% rally on Friday. Hong Kong’s Hang Seng Index rocketed 2.7%. Shanghai Composite rose 2.9%. In the U.S., heavy buying has occurred in call options on iShares FTSE Xinhua China 25 Index Fund ETF /quotes/zigman/357940/delayed/quotes/nls/fxi FXI -0.17% .

    At The Arora Report, we closely follow 15 emerging markets, including China. We provide signals in three time frames; short-, medium- and long-term. We issued a long-term sell signal on China in 2007, as shown on the chart linked below. This long-term sell signal on China is still in effect. On Sept. 18, 2013, The Arora Report upgraded China for the short-term as shown on the chart.

    Please click here for an annotated chart.

    The background colors on the chart represent weighted conclusion of one of the six screens of the ZYX Change Method; green is a buy, red is a sell, and blue is neutral.

    There were several reasons behind issuing the long-term sell signal on China in 2007. The reforms, if properly implemented, will rectify some of those reasons, but not all, as described below.

    One-child policy

    China’s forced one-child policy has been highly successful in controlling the population. However, it is skewing the demographics toward an older population and creating a big imbalance between the male and female ratio. Our research conclusively shows that if everything else is equal, demographics is a big long-term predictor of the stock market in a country. A country with a younger population does better than a country with an older population.

    The reform tackles the demographic issue head on. China is loosening its one-child policy. Investors are enthused enough to buy with both hands baby-formula makers such as Mead Johnson /quotes/zigman/526383/delayed/quotes/nls/mjn MJN -0.94% and Abbott Laboratories /quotes/zigman/216393/delayed/quotes/nls/abt ABT -0.35% .

    Transition to younger generation of leaders

    In 2007, a transition to a younger generation of leaders was ahead. China is not a democracy but an authoritarian regime. Historically, a transition in an authoritarian regime usually poses risks.

    Fortunately for China, now China has completed this transition successfully and this risk is gone.

    China super-cycle is over

    In 2007, our prediction was that the double-digit growth days of China would soon be over. This prediction was made at a time when we were the lonely voice. This prediction has proven spot on. For details, please see China super cycle is over.

    The reform comes to grips with the reality that China is now going to grow only in mid-single digits. Aligning the plan to the reality is a positive development for China.

    Property bubble

    In 2007, we were staring at a property bubble in China as well as in the U.S. For the U.S., our warning of the bubble bursting came true in 2008. In China, the property bubble has simply become much bigger. In Beijing, new-home prices have risen 19% year over year.

    Our early indicators show that the government is not succeeding at controlling the property bubble. This remains a major cause of concern.

    Transition from exports to consumption

    China has to make a transition from an export-driven economy to a consumption-based economy. In theory, the reform plan has several items to help with this transition. In our view, implementing this transition will not be easy, and thus poses a big risk for investors.

    State-owned enterprises

    Euphoric investors do not seem to realize that China is dominated by state-owned enterprises. As the reforms are implemented, profits of state-owned enterprises will go down. Therefore, the Chinese stock market may go down even if the reforms are successful.

    Our long-term rating on China remains a sell at this time, but is likely to be upgraded either on a dip in the Chinese stock market or on early signs that the property bubble is not getting any bigger. Our medium-term rating on China remains a mild sell but may be upgraded if the Chinese stock market pulls back. Our short-term rating on China remains a mild buy.