Weekender: Did China Just Ring a Bell?

January 9, 2011
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As the old saying goes, they don’t ring a bell when a market tops.

But sometimes it sure feels like it.

Two quick examples: The first from my days as a wet-behind-the-ears commodity broker in 1998.

I had come into the biz near the tail end of one of the most vicious commodity bear markets of all time. The president of the firm, a diehard grain bull, was convinced everything was about to turn around. Many of our big clients were farmers and he couldn’t bring himself to go bearish, repeating the mantra to “never short anything below the cost of production.”

A big crop report was coming out, and the whole office was bullish on soybeans. “Beans in the teens!” was the rallying cry, though soybeans were only pushing $6.00 per bushel at the time.

The crop report came out, and the news was incredibly bullish — just as we had anticipated. Soybean prices were set to explode! Except they didn’t. The futures climbed a couple cents on the open, then ran out of gas and slumped lower on the day.

The boss was frustrated beyond belief. “I give up!,” he shouted, throwing up his hands and walking out of the room.

Wheels were turning in my rookie brain. “If beans are that weak in the face of a big bullish report,” I thought, “maybe we should be shorting them in size.”

Unfortunately, as the “new kid,” I didn’t have the moxie to act on that idea — or the guts to go against the rest of the firm. And it was too bad… over the next eight months or so soybean prices plummeted, hitting a mind-boggling low of $4.02 per bushel in July 1999. I have little doubt that at least a handful of traders, more seasoned and more objective, made an absolute fortune on that move

The second “bell ringing” example comes from June 2007, when the Blackstone Group went public.

Those were the days of private equity euphoria. In March ’07 The Economist had declared PE guys “the kings of capitalism.” In an over the top cover splash, Fortune magazine declared Schwarzman himself “the new king of Wall Street.”

Private equity had ridden a wave of cheap money mania to the ultimate leveraged glory, and Schwarzman was cashing out — via the IPO — at the perfect time. Fortress Investment Group (FIG) had gone first, making its founders billionaires on paper. Blackstone represented the crescendo — confirming Schwarzman a sort of diabolical genius.

Given that private equity’s game is to fix up assets and then hand them off at peak valuation (or as close to that as possible), you had to give Schwarzman a golf clap. The hype, the mania, the buildup, the final coup of selling at the most breathless moment — it was perfect.

BX (the Blackstone ticker) debuted on the NYSE in the rough vicinity of $35 per share.

It pretty much went straight to five bucks after that.

So why bring up these stories? Because that old “bell ringing” feeling is in the air again…

You know those tired jokes about how Hummer and Ferrari drivers are “compensating for something?” One could say the same (on a national scale) when it comes to tall buildings. The desire to show off the world’s tallest building is a sort of reliable ‘tell” for excesses of hubris and economic leverage.

The von Mises institute has an article describing this phenomenon, Skyscrapers and Business Cycles. Bottom line being, the skyscraper indicator has “a good record in predicting important downturns in the economy.”

As the above graphic shows, for some time the world’s tallest building has been the Burj Khalifa in Dubai, opened in January 2010.

So getting back to the bell ringing, I give you “China plans $1.3 bn seven star hotel:”

Beijing authorities plan to build a “seven-star hotel” modelled after Dubai’s Burj Khalifa — the world’s tallest building — in a $1.3 billion joint project with Saudi Arabia.

The hotel will be erected in western Beijing’s Mentougou district some 30 kilometres (18 miles) from the Chinese capital’s centre, the state-run Beijing Morning Post said in a Thursday report, quoting a local parliamentary meeting…

Classic isn’t it?

Noted bear Jim Chanos has said that China is “Dubai times a thousand.”

China’s planners seem to have taken that statement as a compliment — or even a pledge to live up to — as opposed to a dire warning.

The air is rich and thick with irony… and hubris-fueled stupidity. Considering that China is in the grips of a white hot real estate mania, you’d think the last thing they want to do is invite comparisons to a major league fiasco that wound up like this (Time Magazine, Oct 2010):

There’s a half-off sale in the world’s tallest building.

Even with an address at the iconic Burj Khalifa, rents for residences in the tower are not immune from Dubai’s real estate crash. Indeed, nearly a year after it was inaugurated with a massive water-and-fireworks display, about 825 of the tower’s 900 ultra-luxury apartments remain unoccupied, according to Better Homes, a real estate brokerage in Dubai…


Geniuses… or Idiots?

And by the way, this topic brings up a little bone I have to pick with the China bulls.

As of this writing, bullish views on China are extensive and widespread. Underscoring much of this bullishness is the implied belief that Chinese planners are “smart” while the American government is “stupid.”

Beijing, and China at large, is supposedly being run by savvy geniuses who will successfully manage away all problems (like rampant inflation) and not put a serious foot wrong.

After all, while American politicians play “checkers,” China is populated by serious long-term thinkers playing the subtly complex strategic game of “Go.”

Uh-huh. Yeah.

I ask you, how incredibly out of synch with history is this conveniently bullish viewpoint? Over the centuries, the millennia even, the track record is clear: Governments are cack-handed and dumb. If they do not start out dumb, they wind up dumb. Hubris, overreach, and the great weight of managing complexity overtakes them.

The old saying, “shirt sleeves to shirt sleeves in three generations,” could well apply to economic booms in modified form. Even the founding fathers of the United States made plenty of gargantuan economic mistakes.

What’s more, the “China won’t falter” narrative is all the more impossible given that the historical track record of major power success is one of experiencing crisis, dealing with crisis, and eventually overcoming crisis — not sidestepping it completely through slick management!

And yet now we are supposed to believe the Chinese government is different? That these guys — a bunch of dusted-off communists no less — have cracked the code?

“Not bloody likely,” as a subject of the defunct British empire might say.

Just for fun, let’s go with the hypothesis that maybe China’s leaders are not geniuses but idiots… run-of-the-mill knucklehead types as with other heads of state. What evidence might we have for this assertion? How about the following:

  • China has bet its future on an aggressively mercantilist and, in the eyes of some, massively protectionist growth strategy that could wind up blowing up in its face (via Western backlash) at precisely the wrong time.
  • China has “bet the farm” on its ability to avoid devastating breakouts of strife and civil unrest, born as direct result of a mercantilist strategy that holds back purchasing power, holds down wages, and pumps up internal inflation pressures (in a country where food and energy costs still represent the lion’s share of domestic income).
  • In its effort to hoover up large volumes of business, China has forced major portions of its export sector to live or die on razor-thin profit margins, leaving these businesses exceptionally vulnerable to new threats of economic downturn, modest currency revaluation, or state-subsidized financing withdrawal.
  • China has presented itself as the savvy accumulator of huge amounts of U.S. debt, potentially without realizing it is the “fish” at the poker table. (If I sell you a mountain of worthless paper and convince you it is worth something, who exactly is the sucker here?)
  • In embracing runaway stimulus and out-of-control money pumping, China has embraced the failed policies of Alan Greenspan, even after observing what the Greenspan mentality hath wrought.
  • In dragging its feet on reining in a real estate mania, China is willingly setting itself up for a “Dubai times a thousand” scenario, even after observing what such in the United States, Dubai and elsewhere hath wrought.

We’ll see how things play out of course. And one would be wise to heed the great Stan Druckenmiller’s advice, re, “never use valuation to time a market.” (That’s what price action is for.)

But I humbly submit before the market court of opinion that China’s leaders are most likely dumb, not smart — not necessarily excessively so, but in the same manner and fashion that all other governments have proven themselves dumb over time.

And with their new “let’s be like Dubai” intentions, they are working hard to confirm it…

JS

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6 Responses to Weekender: Did China Just Ring a Bell?

  1. @PhotonFanatic on January 9, 2011 at 5:24 pm

    It may be a stupid project, but how dumb can the Chinese be, if the Saudi's are footing the bill?

    • Jack Sparrow on January 9, 2011 at 6:58 pm

      Good question, though surely there is more to the deal. The Saudis may be generous but not that generous. Or perhaps China's provinces are just getting while the getting is good.

  2. flyer on January 9, 2011 at 11:15 pm

    Captain, I like this 90% article but I think you were mistaken for a few points.
    1. Chinese workers' income and net worth growth still exceed inflation by wide margin, there is no threat of large scale riots at this moment.
    2. Buying US debt was a shrewd political calculation. They pretended they had no ambition, just wanted to sell a few cheap products and save money in customer's saving account. With help from US elites, they engineered the greatest wealth transfer in human history, as well as technology by the way. Today If USD lost 50% value it won't be a big problem for China.
    I think Chinese economy is a bubble and will experience epic bust. But it is not because they are stupid. They know exactly what they are doing. The problem is, the RE and infrastructure bubble was allowed to be sustained in oder to maximize the benefit for ruling class and special interest group. I think we are years away from the end of Chinese Miracle, prolly more than one business cycle away. We have to see inflation becomes really scary at first.

    • Jack Sparrow on January 9, 2011 at 11:26 pm

      Well, to clarify, the "dumb" stuff was a little bit tongue in cheek. Broader point being that governments, especially arrogant governments, tend to make mistakes — potentially serious ones — that can show up with delayed but spectactular effect at the end of boom cycles.

      As for what happens if the US slows down, I would argue that is a huge unknown. The world still cannot be certain what type of foundation the "Chinese miracle" is resting on; it may be real, or it may be a potemkin village.

      I am not so sure China's leaders "know exactly what they are doing." I would think more they are playing the cards given them as best they can, with the main challenge being preserving the rigid authority of a semi-totalitarian regime in an increasingly hard to control dynamic economic environment.

      As for inflation becoming really scary, within China it is arguably already that.

      Re, end of the miracle, keep in mind too the American 19th and 20th century experiences. America had multiple panics and catastrophic scares on its way to global dominance. If China rises to global economic dominance it is likely to follow the same path. The thing that amuses me most about China boosters is not their conviction that China will rise and conquer all — which is possible — but that it will happen without any major busts in the interim, which does not fit the pattern of history at all. The question is not if China's economy will experience crisis, but when; and following that whether the "miracle" will survive it.

      Thanks for the comments!

  3. Dan on January 10, 2011 at 7:18 pm

    Enjoyed the article and good perspective on how the Chinese miracle is regarded by the US and others as the result of smart moves by the Chinese government. Agree that inflation is going to be a problem going forward with food prices especially. Interest rate hikes and banking reserve requirements are not working to slow it down either. The Chinese gov can't restrict access to credit or they risk slowing the economy too much. Add in the insatiable thirst for commodities – especially gold – and we have the makings for an interesting currency war. Perhaps a revaluation of the Yuan upward is in the cards?

  4. Dan on January 11, 2011 at 9:02 pm

    That was timely! Wondering how a mercenary trader would react to a revaluation of the RMB? http://ph.news.yahoo.com/rtrs/20110111/tbs-us-chi

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