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Dr. Gloom Sees Dark Long-term Picture for China Stocks

China stocks took a breather in Hong Kong Monday, enjoying a holiday after the most recent European effort to resolve its debt crisis sparked a huge rally Friday.But in the last year or so earlier

China stocks took a breather in Hong Kong Monday, enjoying a holiday after the most recent European effort to resolve its debt crisis sparked a huge rally Friday.

But in the last year or so earlier gains from debt-busting measures in Europe quickly eroded in volatile trading. What investors need is an insight into longer-term trends.

Of the analysts I’ve spoken to over the last year and a half, one of the most right-on in predicting China market directions is someone I’ll refer to as Dr. Gloom.

The appellation is handy because he asks that I not use his name or the name of company he works for. It’s also appropriate because he has consistently been more skeptical than most about chances for a lasting upturn in China stocks. He may not be gloomy by nature, but that is where the evidence leads him.

I can say that Dr. Gloom is an ethnic Chinese analyst for a non-Western brokerage. He is experienced, having gone through the shock of the Asian Financial crisis of the late 1990s and the Hong Kong market boom in 2007.

He was unenthusiastic about prospects for a late-2011 rally when other experts were nearly unanimous in predicting that falling Chinese inflation would lead to a loosening monetary policy that would spark a major rise in stocks. In fact, inflation proved hard to tame, and there was no significant monetary loosening or rally.

Early this year statistics revealed the Chinese economy was struggling. Many analysts said the downturn would be short-lived. Dr. Gloom told me at the time that he thought China’s economy as even worse than published statistics indicated. He was right.

Now, the good doctor’s vision for the next few years could be called gloomy.

His main point: China is not merely going through the typical business/market cycle; it is starting a difficult economic restructuring.

“China is undergoing a structural change(;) treating it as a cyclical change and trying to find clues from historical data could lead to the wrong conclusion,” Dr Gloom told me in an email. “How long will China ’s downturn last? I do not know, but it will likely be longer than most people anticipated, perhaps 3 years.“

He pointed out that from 2000 to 2012, China relied on exports and fixed asset investments (FAI) to fuel spectacular growth. But higher domestic costs and dwindling demand from overseas hurt exports. FAI must be scaled back because it led to overcapacity in some infrastructure areas and to an overheated property market.

“The old model does not work any longer, China needs a new model – therefore structural change,” the doctor said.
Not only does no one know how long it will take China to find a new growth model, he said, no one knows if they will even find a successful model.

“If China fails to find any replacement growth driver (possible), then it is the demise of the China … story,” he said.
On the stocks front, Dr. Gloom said it appears China’s A-share market may have bottomed out, but that Hong Kong stocks have not. The worst case scenario of the blue-chip Hang Seng Index is 14,000, especially if news from Europe is bad. The index closed at 19,441 on Friday.

A modest rebound up to 20,000 is possible in the third quarter if European leaders continue to come up temporary policies to ease the debt crisis and China makes some moves to loosen monetary policy.

“(There is) no real investment opportunity but plenty of trading opportunities,” the analyst said. If China slightly relaxes monetary policy in the second half of 2012 there are a few sectors that might gain.

Chinese banks have a shot because they are very cheap and additional bad debts won’t be booked in 2012.
In aviation demand is strong, there is no excess supply and fuel prices are falling. His brokerage likes Air China (AIRYY).

There may be trading opportunities in steel, metal, cement, coal even though serious over–supply problems persist. Dr. Gloom said loosening policies in China may lift these sectors for a few days or weeks.

The big global problem, as Dr. Gloom sees it, is that China, the U.S. and Europe are all going through difficult economic restructuring and economic growth in all three regions is weakening.

He said failure of Europe to reach a rescue agreement could trigger “the big crash.”

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