In this week's edition of GreenThought$, an avid reader asks a great investment question about China and Japan.  I'll try to provide a thorough answer.

 

Our thanks to Ken Snowe, a regular GreenThought$ reader and seasoned independent financial advisor in my home state of New Jersey.  As Saturday Night Live historians will remember, the Garden State was also home to a Mr. Richard Fader, the made-up character who always wrote questions to Gilda Radner's great Rosanne Rosannadana news reporter character.  Ms. Radner would read a long list of questions and then say, "Mr. Fader, you sure do ask a lot of questions for someone from New Jersey." 

 

Well, Ken is no Richard Fader, but he is a veteran advisor who was curious about the global stock market environment, and in particular China and Japan.  The media had developed the phrase "Chindia" to refer to the powerful combination of two of the world's fastest developing economies, China and India.  Ken's question dealt primarily with China and Japan, thus, the title of today's GreenThought$.  Here is his question and my answer.  And as my grandmother used to say to me...it's always something...

 

Question:

While I read all of Emerald's emails I am wondering whether you have concerns about China and Japan.  A good friend of mine is a broker in Atlanta and he has alerted me to his concerns that all may not be well even in China (and Japan continues to worry me as well).

I am meeting with my more cautious and older clients encouraging them to be more defensive. Most of the financial press is sending encouraging vibes about economic progress, but I don't see this in everyday life. So, I am looking for information supporting my unease. My gut tells me that the market can go either way during the balance of 2010. While the private sector is healing, there are public sector layoffs galore in the Northeast at least. These layoffs aren't going to help fix the housing and personal debt crisis. But, my big concerns are overseas. Does Emerald share this view?

 My answer:

 

This is all about time-frame.  If we look out over the next year, all markets appear to be hanging over a cliff, grasping the hand of a friend to keep them from falling.  That friend is the sovereign governments of the U.S. and several other developed nations.  If some market shock were to occur, we suspect that, as in the past, it will affect all global stock markets.  When the U.S. sneezes, China, Japan, Europe and Latin America all catch a cold.  The reverse is true as well.  It's a globally-intertwined market no matter how you look at it.

 

Specifically in the two markets you mentioned, China's stimulus package was effective at the start but the country's high GDP growth rate will be tough to slow, making a crash landing possible.  But again, since this is nothing new to investing in Emerging Markets, we should not be surprised if on the way to what could be a 10-year return of several times one's initial investment, there is heartache along the way.  The beauty of our asset allocation approach, and specifically our use of non-U.S. holdings, is twofold: we allocate each piece of capital entrusted to us in a way that we feel offers the best tradeoff between reward and risk at a particular time.  Those decisions may be based on something we see over the next several months, but more likely over a longer period of time. 

 

Within the Global Cycle strategy, we can hedge using inverse ETFs, inverse mutual funds and cash.  We don't have to sit there and take it when markets fall hard.  Given the 5 - 10 year time horizon of this part of the portfolio, we don't expect to hedge out all volatility, but aim to cut it down and raise it as needed.  So if China falls hard, we have ways to potentially reduce any damage.

 

As for Japan, I call it the Rip Van Winkle market.  Ol' Rip could have fallen asleep back in 1988, awoke today, and find he did not miss anything good in the Japanese stock market.  As with the problems in the U.S., Japan is faced with what to us is an obvious mess.  However, the ultimate ruler is price, and stock prices stubbornly rose for many months without what to us is a now long overdue correction.

 

So, we see the China/Japan issues as we see much of the world today: equities are overvalued, but that is less important than the fact that buying pressure is outweighing selling pressure, so stock prices keep rising.  We are aware of the issues that can arise and ruin a portfolio, and are as always vigilant in monitoring and hedging them as we feel needed, with the goal of providing as smooth a ride toward long-term capital growth as possible.  We have owned a position targeting the China equity market in our Global Cycle Separate Account since it opened in September, 2005.  One of the most attractive global secular themes we see is the long-term ascension of the Chinese economy.  It is a well-known story today: this gigantic nation of billions of people, formerly under very tight Communist government control, and a source of low-cost labor for developed nations, began to emerge on the world scene.  Gradually, Chinese markets continue opening up to foreign investors, and China itself has become an investment force.  The country is the largest U.S. creditor, and despite the periodic concerns about whether China will revert to its hard-line ways, it appears to us that it is the next world economic leader.

 

This conclusion was not so obvious back in 2005, when we assessed the global markets and decided that China would not be an "emerging" market forever.  At some point we felt it would be judged to have emerged, and would take its place beside the U.S., U.K., Japan and Hong Kong as a formerly nascent market that became established. In our opinion, this process would take years, perhaps decades.  Our belief was that along with India, China was going to develop into a world economic power and trading partner, but the ride to that destination would certainly be bumpy, even panicked at times.  We also thought the rewards would more than justify the volatility we anticipated.  At the same time, our newly-minted Global Cycle portfolio had the flexibility to hedge its positions, either specifically (e.g., short ETF on China) or broadly (e.g., short ETF on S&P 500 or another broad market index).  With the availability of these hedging tools and the ability to raise portfolio cash levels, as well as a mix of other attractive secular portfolio themes, we initiated a position in China in September, 2005, on the day the Global Cycle portfolio opened for business.  We may adjust our position up or down from time to time, but the secular China theme appears to be very much intact.

 

(c) Emerald Asset Advisors

www.emeraldassetadvisors.com