Next stop for the traveling global financial casino: China

03/06/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The global casino is moving on.

Now that the European Central Bank has flooded the European banking system with 1 trillion in euros, and now that Federal Reserve Chairman Ben Bernanke has said that the U.S. central bank isn’t thinking of a new program of quantitative easing, the best candidate for a big injection of central bank cash into global asset markets is the People’s Bank of China.

So the big money is moving on. In the new “Paranormal” market (see my March 2 post http://jubakpicks.com/ ) global cash flows count more than economic or company fundamentals. At least in the short term.

Italian banks such as the country’s biggest UniCredit or Banca Popolare di Milano Scarl closed March 2 up 80.2% and 107.3%, respectively, from the January 9 low. Weak banks did better than the soundest institutions in the wake of the European Central Bank’s lending spree, but even a solid bank such as Spain’s Banco Bilbao Vizcaya (BBVA) is up 18.5% from January 9 through March 2. The run-up in European banking stocks probably isn’t over—but the biggest money has been made and the odds of a retreat in the sector are rising.

Getting in early on the next spin of the central bank wheel in China looks like a more attractive gamble than sticking it out in Europe in the hope that the Greek rescue deal and the EuroZone fiscal discipline pact will produce economic facts to back up the current optimism.

I think that’s true even though China yesterday lowered its target for 2012 growth to 7.5% from 8%. (For my take on the meaning of that change see my post of March 5 http://jubakpicks.com/2012/03/05/china-cuts-growth-target-to-7-5-from-8-but-i-dont-think-chinas-leaders-are-forecasting-slower-growth/ )

Predicting where global cash will slosh next—and then betting on the markets it’s sloshing into and against those markets it’s sloshing out of—is the current name of the investment game for big money players. You may not like this game, but there’s nothing stopping individual investors from making money off these relatively short-term trends.

On the other hand, you don’t need to play in this casino. I think investors that measure time horizons in more than a quarter or two can even make money by picking up bargains in solid stocks in markets that the big money has deserted and holding them until the wheel spins in their direction again.

But play or not, you do need to understand the game, if only so that the short-term volatility doesn’t scare you out of good long-term positions and so you understand why for weeks on end the markets might sell down an absolutely fundamentally sound stock.

So let’s look at why I think the wheel is spinning away from Europe, and toward China, and at some specific stocks to use if you choose to play this turn of the wheel.

A river of denial flows through Europe as leaders bask in the after glow of an almost complete Greek rescue deal (assuming the bond swap takes place on Thursday, that is) and the approval of the new budget discipline pact by 25 countries. French President Nicolas Sarkozy was among the more measured celebrants saying, “We have not exited the economic crisis but we are turning the page. The strategy we put in place is bearing fruit.”

Oh, yeah? What fruit did you have in mind, exactly?

This on the same day that Spain announced, apparently without consultation with its EuroZone partners, that it was resetting its budget deficit target for 2012 at 5.8% of GDP? That’s well below Spain’s budget deficit of 8.5% of GDP in 2011, but well above the 4.4% that Spain promised for 2012 and even further above the 3% that would represent compliance with the EuroZone rules.

I don’t think there’s much of a chance that Spain will hit that 5.8% target for 2012 either. The country’s economy is forecast to contract by 1.7% this year. As I understand the European Commission rules, the Spanish issue will hang fire until May. At that time Spain will either have presented a budget that meets the agreed target, procured a waiver of the rules (extremely unlikely) or face fines from the European Union.

The other troubled economies of the EuroZone face pretty much the same problem over the next half year. The austerity budget plans that have inflicted so much pain on the people of Greece, Portugal, Ireland, Italy, Spain, France, and (soon) the Netherlands—but that have helped stabilize the financial markets for the debt of most of these countries—will have to become even harsher in 2012 as shrinking economies produce falling tax revenues opening up new budget gaps. The Greek economy is now projected to shrink by 4.4% in 2012 and the Portuguese economy by 3.3%. And right now it looks like any potential economic shocks—such as the high price of oil—line up to slow growth even further.

Look at European financial markets from the perspective of a player in the global casino. It’s hard to see why the euro should climb substantially from the $1.3196 rate on March 2. $1.35 possible, sure, but beyond that you’re betting against longer and longer odds. If you wanted to make money on a stronger euro, the time to do so was back on January 12 when the euro traded at $1.2657.

Same with European equities and Italian and Spanish bonds—interest rates on bonds have dropped and prices have rallied. The rally may not be at an end, but it’s in sight.

When?  March if New Democracy wins in Greece and repudiates part of the austerity budget deal. April if Sarkozy loses to Francois Hollande in the French presidential election and Hollande seeks to reopen the fiscal discipline pact. May if Spain decides to defy the budget rules of the European Union. June if the inspectors from the International Monetary Fund and the European Commission give Greece a failing grade, as expected, on its austerity efforts. Whenever, if the spat between European Central Bank head Mario Draghi and Germany’s Bundesbank can’t be smoothed over by German Chancellor Angela Merkel.

It’s not that any of these events are guaranteed to push Europe back into crisis; it’s just that the odds favor a renewed crisis not too far down the road. I certainly can’t come up with a comparable list of events that would improve the current situation.

Right now, I think the situation is too fluid to make shorting Europe an attractive play for global big money—but if the euro keeps climbing and the lineup of events stays the same, I can see a time when the players in the casino would decide to bet against European assets.

When those negative bets go on, I think individual investors will have a good opportunity to add fundamentally attractive European stocks to their portfolios. Not yet, mind you. But this is the time to begin putting together a list of European stocks that you would like to pick up, say, six months down the road—if the price gets to be right. I’ll give you some suggestions for beginning of such a list sometime in the next week or two.

Contrast what to me look like increasingly unattractive odds in Europe with the odds in China (and to a degree in China-related markets such as Australia and Brazil.) I think we’re close, despite the detour caused by China’s cut in its target growth rate, to seeing global cash slosh full force toward China.

The biggest reason to think that’s in the future for global markets is that China’s major central bank action--an actual cut in interest rates—is still in the future. (I’d suggest a potential June/July timeline.) An interest rate cut would, in my opinion, be less important for the stimulus it would provide than for its value as a clear sign that the government has moved from braking the economy by tightening the money supply to stimulating growth.

The bank has already taken preliminary steps that clearly lead in the direction of that defining action. New lending from China’s big banks is on the rise. For example, on March 4 Industrial and Commercial Bank of China, the country’s biggest bank, reported that new loans in the first two months of the year increased by 15 billion yuan from the same period in 2011. The People’s Bank cut the reserve ratio for the country’s banks by another 0.5 percentage points effective February 24. That was the second cut in the reserve ratio in three months. Each 0.5 percentage point reduction in the amount of money that banks need to keep in reserve against loans adds another $65 billion or so to China’s financial system. And Beijing is clearly now in the midst of setting new rules for the real estate sector that would loosen—how far is the big uncertainty—restrictions on mortgages and reduce some taxes on certain kinds of real estate purchases. It’s likely that these rules will get official clarification in the days after the National People’s Congress that began on March 3.

Of course, China’s stocks have rallied in anticipation of this spin of the wheel by the People’s Bank. The iShares FTSE 25 China Index ETF (FXI), which tracks the performance of the 25 largest stocks listed in Hong Kong, was up 35.7% from its October 3 low as of the March 2 close and 14.5% from its January 6 price. (That’s about the time of European stocks started to climb.) But considering that the index was down 36.6% from its November 4, 2010 high, we’re just looking at break even after a nearly 40% bear market. Certainly the 14.5% climb from January 6, 2012 to March 2 doesn’t count as extreme when measured against the gains in some of Europe’s weaker bank stocks.

And in comparison to the relative complacency about European markets—the problem is solved!!—the relative uncertainty about China with substantial numbers of market strategists still calling for a hard landing by China’s economy this summer suggests that there’s still upside here.

If you’re looking for an expression of that lingering uncertainty on China just look at yesterday’s market action.

What cards do you want to bet on to gain a piece of that upside in China?

The big winners from this spin of the wheel in China are likely to be the stocks that lost most during the time when the People’s Bank was clamping down on the money supply. That means China’s big banks and big property developers. The iShares FTSE China 25 Index ETF (FXI) will give you good exposure to China’s biggest banks and a smattering of other financial stocks. If you want concentrated exposure to China’s real estate developers, take a look at Guggenheim China Real Estate (TAO). The fund was up 27.05% in 2012 as of March 2. Of course, it fell 25.6% in 2011. (The global casino is very risky when you get the wrong bet down.) If you can invest in individual stocks in Hong Kong, I’d suggest Evergrande Real Estate Group (3333.HK) for a concentrated real estate developer play. The shares were up 25.14% in 2012 as of March 2.

Let me be clear about this—banks and real estate stocks in China are a great vehicle for making money if you judge the slosh of global cash flows correctly—but you’ll take a beating if you’re wrong. And they can be downright scary if you’re early.

That’s because they’re almost a pure play on these global cash flows—there really isn’t much there there in the way of economic fundamentals to hold up share prices if the cash sloshes in the wrong (from your point of view) direction.

Stocks with actual positive fundamentals will rise with the tides of the global casino too—just not as much as the pure cash flow plays. That also means these stocks have something to hold them up besides the bets on the direction of global cash flows.

Here are two suggestions in you’d like to mix fundamentals with your bets on global cash flows.

Betting directly on casinos in China, as strange as it sounds, gives you a solid fundamental foundation. Gambling revenue in Macau, the only place in China where gambling is legal, long ago passed gambling revenue from Las Vegas. Revenue growth is projected to slow to just 20% in 2012 from the 42% growth of 2011. My favorite Macao play, Sands China (1928.HK), however, is set to open the first phase of a new resort on Macau’s Cotai Strip in April—and that should help offset any slowdown in overall revenue from Macau. The company showed a 70% increase in net income in 2011. If you can’t buy Sands China in Macau, try shares of the parent company Las Vegas Sands (LVS) in U.S. markets. (I’ll post a long-take on the Asian gambling sector later this week including some suggestions on timing any buys.

Home Inns and Hotels Management (HMIN) is scheduled to report fourth quarter earnings on March 8. Earnings estimates for this owner and operator of economy and business traveler lodging in China are all over the place from 21 cents a share to 47 cents. In the third quarter Home Inns and Hotels Management reported revenue of $159.9 million against the consensus of $142.1 million. But fears of an economic slowdown hit the stock hard in 2011 with shares falling by 32.2% from September 14, 2011 through December 19. Since then the shares are up 27.2%. I’d wait and see what the company reports on March 8 before buying—after a 27% gain there’s always a good chance of a sell on the news reaction.

And what about all the big problems not so far down the road—say, 2013? Well, the global casino doesn’t care to look that far ahead. Yes, there is the little matter of how Europe’s banks will repay the 1 trillion euros they’ve just borrowed. And the little matter of all those bad loans that should be on the books of China’s banks and aren’t. And the little matter of how the U.S. government will reduce its huge budget deficit without crashing the domestic and perhaps global economies.

Those things will matter. And those fears will in the future drive the slosh of global cash just as hope drives it now. But the wonderful—or scary thing, if you prefer—about the new Paranormal market is that those long-term realities are realities for another day. And in the meantime the casino’s wheels just keep on spinning.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Banco Bilbao Vizcaya, Home Inns and Hotels Management, and Sands China as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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