Alpha Power Investing Newsletter

April 1, 2010

Bubble #386

If you want to know where the next investment disaster will come from, just follow the flow of money into mutual funds. Right now, the big story is emerging markets - investors are loading up on these funds as if there's no tomorrow.

Investors love a story and the emerging markets story is compelling - young, growing populations, strong consumer demand, strong work ethic, high GDP rates.

The problem with compelling growth stories is that they become compelling late in the game.

The biggest story is, of course, China. With its 1.3 billion inhabitants, low income per capita, cooperative government, industrious work ethic, a focus on growth, and a great track record (GDP up 16x over the past 30 years), they look unstoppable.

Back in 1989, the big story was Japan Inc. Investors poured money into Japan funds as pundits predicted that the Japanese would take over the world and buy up the best of our assets (they were buying U.S. real estate at a blistering clip). Simultaneously, Japanese real estate was on fire due to low local interest rates and the easy availability of credit. The Japanese stock market briefly traded over 40,000.

But it was an illusion. The Japanese market today is around 10,000 and the Japanese economy continues to stagnate despite years of profligate government spending designed to stimulate growth.

Professor Elroy Dimson of the London Business School is one of the foremost authorities on emerging markets and their historical returns. Based on his research, countries with the highest growth rates have stock markets with the lowest long-term returns. Based on data from 53 countries, spanning 100 years, he found that stocks in countries with the highest economic growth rate earned an average annual return of 6% vs. those in the slowest growing nations which averaged 12%. When it comes to China he says, "You're paying a price that reflects the growth that everybody can see."

The China story feels a lot like the Japan Inc. story of 20 years ago. The major Chinese banks are controlled by the state. They are lending like crazy.

In the 1980's large Japanese banks were seen as instruments of the Ministry of Finance and therefore, immune to losses. At that time they enjoyed the largest market capitalizations in the world. During the 90's these banks generated losses equal to twice their initial capital.

According to Morgan Stanley, over the past decade, national home prices in China rose at an annual rate of 8%. This constant appreciation has convinced the Chinese that the housing market is a sure thing. Average home prices were up 8% in 2009 and several local markets rose by 20% or more. Speculators are rampant: a recent survey found that nearly a fifth of all recently sold properties were kept vacant, since new apartments tend to fall in price if they are rented out.

Sound familiar?

Like all bubbles, it's hard to say when they will pop. But China today sounds a lot like Japan Inc. 20 years ago.

The first commandment of investing is this: take no unnecessary risks. To me that means passing on the compelling growth stories.

Jerry Minton, Ph.D.

© 2010 Alpha Investment Management Inc.

Alpha Power Investing Newsletter Archives