Return of the Dragon

China China China. It's simply been on fire for the past two years.


All markets, in fact, are at all time highs, so the eternal search for "new money" plays is especially difficult currently. Rather than provide an outright endorsement, this article is more of a reflection on mightiness. Contemplating whether these China plays are overheated is perhaps much like philosophizing on how to attack Bruce Lee only to get a nunchuck in ones face.

• FXI - this index of 25 domestic plays is the "Dow Jones Industrial" of China. Includes the following prominent components:
  
• PTR - PetroChina - consider this the ExxonMobile of China
  
• CHL - ChinaMobile - the AT&T, Sprint, T-mobile, Vodophone, and Verizon of China
• ACH - Aluminum Corp - China's demand for raw materials is simply insatiable.
  
• BIDU - the Google of China. In my 6 trips to Beijing over the past 2 years, I got ample confirmation that all the natives use this engine (official number is over 70%). They say that is simply understands the Chinese language better. They also say it has a killer feature that finds free mp3 music.
• SINA - the Yahoo of China. A popular portal and e-mail service.
  

A few basic factors to consider with China investments are:

+10% growth. Each % of GDP growth has a profound effect on the standard of living residents and business environment of a country. China has sustained GDP growth of over 10% for over 4 years straight. The last time it was at all comprable to US growth of 3-4% was 1989. The US is still vastly larger, but the gap is shrinking fast, and the market has always rewarded growth.

Undervalued currency. Because it maintains a peg to the dollar, the RMB would be much stronger if it were ever to be let loose. The current exchange rate is ~7.5 to 1 dollar. Only last year the predicted true-value was 6 to 1. Now after the dollar slide, the predicted value is 5 to 1. Yes, the peg allows cheap exports, but most FXI components are dominated by domestic sales. So a complete float of the RMB has a 50% upside for US investors of the FXI, and provides a hedge against total dollar erosion in other investments if such an event were to ever happen.

Massive Reserves. The Chinese government has over a trillion dollars of hard currency reserves. This provides an implicit insurance policy for FXI components, as the Chinese government would likely not let any of the component companies fail.

Risks: plenty. Mostly to do with highly overvalued multiples, arbitrage situations where shares have completely different rules and prices for foreigners vs. domestic investors, and banking issues within China that still need to be sorted out.

New $5 USD Bill released today

To stifle counterfeiters who would bleach $5s and make them into $100s, the Federal Mint today released its new grey/purple "honest Abe" fiver.

Since M2 (the # of $ in circulation and in all checking and savings accounts) has effectively tripled in the past 20 years, it is nice to know that when these dollars are pulled out in the form of M1 (the # of $ in physical paper money form) that they will look nice and have the latest security features.

Fed cuts rates by 0.5%

Executing the first ever cut by the Bernanke led Fed, the Fed Funds Rate is now down to 4.75% from 5.25%. Conforming 30 year fixed rates almost immediately dropped 1/4 point to 6.0%. The US continues to ease market fear with cheap, diluted dollars. Stocks cheered, many up 3-5%, but will the euphoria continue to push the S&P500 and other indexes to new all-time highs?

Apple moving into video rentals?

Rumor has it that a meddling user stumbled across some interesting help pages in the iTunes support site. They found links for "wrong video rental received" and other things that implied that Apple (AAPL) may be planning to enter the video rental market. Similar to book retailers, which got gutted by online vendors such as Amazon (AMZN), video rentals which used to be delivered by throngs of mom-and-pop corner shops that are now being threatened by a few online giants:

• NetFlix (NFLX) - The inventor of the concept of mail-in DVD rentals now has everyone after them. Their only hope to achieve dominance is to build their national brand-name outside of their comfort zones (local city market such as the Bay Area) and add subscribers.
• Blockbuster (BBI) - Trying to leverage their bricks-and-mortar strength to add value to and steal away the NetFlix business model.
  

The Wandering Economist

This is an interesting audio Podcast on economics. Be sure to listen to the ones on inflation and ending the gold standard (Bretton Woods Agreement).

Apple offers more for less

Apple (AAPL) continues on its path of being a consumer super-product assembly line. Today it announces several new iPods including one with WiFi capability, and slashes the price on its sizzling iPhone device by $200. These moves should drive its volumes up and improve its market share in the smart phone market. The stock has been volatile in between $120 and $145 over the past few weeks, with investors buying aggressively on weakness despite an over 50% YTD gain thus far. There are many reasons for Apple to remain strong within the technology segment. Besides now being perhaps the largest % component of the Nasdaq 100 Index (QQQQ), it has a small and growing ~4.5% share of the OS and PC market, and a relatively low market cap compared to MSFT and INTC.

Liquidity Scare

This sub-prime lender crisis is well underway. Countrywide (CFC) is undergoing serious issues and may go bankrupt. Capital One closed a large lending arm (Greenpoint). Many financial companies have tanked drastically. There are reasons to believe that things aren't as bad as the markets are making them out to be however. If the wider impact of these sub-prime issues turn out to be overblown, some potential companies to look into are:

• Thornburg Mortgage, Inc. (TMA) - Lender to wealthy, high quality Jumbo clients. Highly leveraged, but their loans are unlikely to default.
• Deerfield Capital Corp. (DFR)
• RAIT Financial Trust (RAS)
• Crystal River Capital, Inc. (CRZ)

All of these issues have high dividend rates, low P/E, and are valued well below their book value currently. Each hit a massive low in mid August -- down over 50% from June. If fears subside, some nice speculative gains may be possible.

A note on sub-prime: when mortgage rates (10-year bond + ~1.75%) hit a historic low in 2003, many borrowers over-leveraged themselves with very cheap 5-year ARMs or interest only loans. The low 2002 rates are beginning to expire, and while some borrowers were already paying 50-75% of income for their housing, they now cannot sustain the increased cost of their ARMs going to a variable rate. As these 5-year ARMs move from fixed to a variable rate tied to the Fed Funds Rate or LIBOR, which has risen by 2-3%, borrows are faced with paying hundreds of dollars a month more for their mortgage. With housing prices softening, more borrowers in such situations are going into foreclosure. This phenomenon is likely to continue into 2008 as the 2003 ARMs expire. Also, with the dollar weakening and inflation growing, there will be pressure for rates to go up over time. However it turns, this should be an interesting trend to follow.

Materials Rush

Materials related stocks are doing far to well to not take notice. Copper, iron, nickel, gold all are commanding strong prices on the commodities market, and have many good value (low P/E) producers:

• Southern Copper Corporation... PCU
  Insane growth + a ~10% dividend
• Companhia Vale do Rio Doce (ADR) RIO
  Generates much of the world's iron
  
• Freeport-McMoRan Copper & Gold... FCX
  Just acquired Phelps Dodge and has ~8% dividend
  

Volatility Correction

The China market has been overheated over the past year, and has finally made its much needed correction. The best tracker for China is perhaps the FXI index of the 25 largest domestic companies. This fund has gone up 80% in 2006, and was begging for correction. Unfortunately the correction came and seemed to spark a massive sell-off in US and world equities. This too could be largely anticipated because the volatility index ^VXI has been so low. Basically, there has been less and less volatility over the past 3 years. So this correction single handedly created a spike in the ^VXI that seems to most closely mirror a pattern last seen in 94-95, and suggests an instantaneous "fear factor" akin to 9/11/2001. Seeing how there is no comparison as far as context for the correction, perhaps it will be short-lived and not indicate a general downturn of the markets.

NYX Crash!

Well, the shorts were right in a big way. NYX is down 15%. Will it find strength, or is Kramer going to be shamed? The arguments against it are the high multiple, and the insane competition in online trade execution. The new NYX hybrid system is apparently 10 times slower than the Nasdaq and other systems because it is new and mimics the auction style system the original floor traders used. On the flip side, it is on a tear to merge with partner exchanges internationally (Euronext, India, Japan), and is leading in ETF trade volume.

Macao Casinos

Macao will soon surpass Las Vegas as the gambling capital of the world. Which players stand to benefit? This site tracks all the players: Gambling Floor. Here is a summary, sorted by market cap:

• $38 billion - LVS - Las Vegas Sands - Will have the most tables and floor space and plans to be the market leader in Macao with the Venetian by 2006. Modest player in the Las Vegas market.
• $20 billion - MGM - MGM / Mirage - By far the largest player in Vegas; owns almost every major casio you've heard of. Is building a 50% owned MGM Grand in Macao to be opened in 2006. The partner is Stanley Ho's daughter. This one is the closest to a value play within the group. MGM is half owned by a billionaire who would like to buy out the whole business.
  
• $11 billion - WYNN - Wynn - Targeting the higher end clients. Has a primary license to the land straight from the Macao government, and is an early player in the market.
  
• $8 billion - MPEL - Melco - Will be the #2 in number of tables once the "City of Dreams" is opened in 2007. Has the most slots with its Mocha club franchise. IPO was less than one month ago. Has effectively no revenues until City of Dreams is ready.
  

NYX -- Skyrocket to the shorts expense?

NYX (NYSE Group, aka Ney York Stock Exchange) has an enormous short position right now. Nearly 50% of the outstanding stock is on loan by people who presumably think it will go down so they can sell it at a profit for less than the value they acquired it at. Meanwhile, KRAMER is calling this security his #1 growth stock of 2007, and there are many buyers who believe their earnings growth and cost cutting will lead to huge gains over the next year. How will this situation resolve itself, and why is it happening. One article on the topic is here: http://vodiagroup.com/pdfs/RegSHO.pdf. The theory is that somehow, market makers got themselves into a mess and borrowed excessive amounts of the security to keep up with immediate trading demand. If new SEC rules pass, they will be forced to correct these positions within 2 weeks. The other theory is that the shorts are trying to profit from risk arbitrage as the Euronext merger progresses. There is no way to know for sure, but the situation will certainly lead to higher volatility activity in the future. I wish I understood the dynamics more. The most likely scenario that seems easy to understand is if the stock starts going up some more: the shorts will be forced to cover at a painful expense. The other direction is more difficult to resolve. Sure the multiple is high, and Nasdaq (NDAQ) is a serious competitor, but is a $7 billion bet that investor enthusiasm will wane worth the risk?

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