growth in China: the (semi-) bearish case

August 30, 2011 By dduane in Asian economic development, China, economics, emerging markets, Hong Kong, Portfolio management, Strategy Tags: business, China, economics, economy, emerging markets, investing, investment performance, investment strategy, stock market Leave a comment

hurricane aftermath

Another day without internet access or TV. We still have water, but it’s contaminated. And the pressure is dropping. At least there’s electricity—which makes us considerably better off than most of our friends and neighbors.

I managed to find a Panera with working internet yesterday. It was so packed with other information-seekers that I barely found a table. The connection was slower than dial-up (if I really can recall what that was like).

It’s hard to get around here by car, since so many trees and power lines have fallen and blocked the roads. Our town says electricity won’t be restored to everyone before Friday. So we probably won’t be able to get back to our “normal” worries about the decline of the US, the dominance of China and the potential implosion of the EU until after the Labor Day holiday.

the bearish China case

Speaking of China, the same issue of Foreign Affairs (Sept.-Oct. 2011) that contains the bullish article I wrote about yesterday, also has a second. It’s “The Middling Kingdom: the Hype and the Reality of China’s Rise,” by Salvatore Babones, a Senior Lecturer at the University of Sydney, Australia. It argues the opposite. It says the world wildly overestimates China’s future power.

Here are Mr. Babones’ reasons:

Like the US, the Chinese economy has benefited in the recent past from increased female participation in the labor force. But, but for both China and the US, this temporary boost to GDP from a large influx of new workers has passed its peak. For this reason alone, future GDP growth will be slower (for both countries).
Increased longevity of parents plus the one-child policy will mean Chinese adults will be spending less time working and more and more time caring for the elder generation.
Urbanization, a key aspect of China over the past two decades, has given a big boost to productivity as workers turn from subsistence farming to industrial work. But urbanization has gone about as far as it can go in China (why isn’t made clear). Like increased female participation, this second turbocharging factor won’t be firing up the Chinese GDP growth rate any more.
Back to the Silver Generation for a moment. In addition to citizens working less, according to Mr. Babones, an increasing number of workers will be compelled to shift from high productivity, high value-added manufacturing work to low productivity service jobs taking care of the elderly. So China will no longer enjoy such a high-octane “mix” of new jobs as it does now.
China’s growth to date has been highly destructive to the environment. It doesn’t have much environment left to destroy. Therefore, future growth cannot be as polluting as it has been in the past. Part of the future price of growth will be pollution control devices. Therefore, growth will be more expensive.
China has reached the point where it is a highly efficient manufacturer. The next step for it would be to spawn a generation of creative pioneer entrepreneurs, like those behind Apple or Google, who will imagine and build highly innovative products. This is unlikely, however, given the tight control the Communist Party keeps over all aspects of the Chinese economy. Non-conformity isn’t a virtue in China.
China’s population will begin to fall after 2020. Adding a shrinking workforce to shrinking productivity may be a recipe for 3%-4% real GDP growth, if that; it isn’t one for a 10% rate of advance.
(not so much a reason, if you get down to it, as an observation) All of the academic predictions of future Chinese strength are based on computer models that take the facts of China’s recent past and extrapolate it far into the future. This is probably the best that econometric modeling can do, but that’s more a commentary about the limitations of computer models than assurance that the conclusions are correct. (In the late 1980s, for example, the predecessors of today’s computers were spewing out the same sorts of predictions about Japan. Look how that worked out.)
The surge in the Chinese economy over the past twenty years has restored the country to the relative place in the world that it held in1870. Last time it got to this point, it regressed; why should this time be different?

Mr. Babones’ conclusion: “ If the international system comes to see China, and China comes to see itself, as an important but not all-powerful participant in the global system, irrational fears will diminish on all sides…”.

Implications:

While it may turn out to be a correct, I’m not persuaded by #9. Maybe repeated invasions had something to do with China’s poor experience last time around?

#8 is Garbage In, Garbage Out said another way.

As to #1-#7, there’s no guarantee that China will stumble over any or all. Nevertheless, this is a useful checklist of early warning indicators to be monitored for signs that the China “story” is coming unraveled.

As/when Chinese economic growth begins a deceleration, I don’t think the country will come to a screeching halt. Nor do I think that signs of slowdown will be evident for at least the next several years. In fact, I think that if anything the developing world is still underestimating near-term prospects for both the Chinese consumer and the Chinese manufacturer.

But if we think of China as a growth stock—better than expected profits for longer than the consensus expects—the Babones article raises legitimate questions about the duration of growth. If/as his view gains acceptance, it will mark an end to one of the two types of “blue sky” open-endedness that characterizes a true growth phenomenon.

What would this mean? –that simply betting on Chinese growth won’t be enough. World markets will either focus on some other secular growth story or, more likely, will begin to focus more narrowly on Chinese industries or regions where growth still abounds.

What to do? For now, I’m going to cheerfully continue to bet the Chinese economy will keep on surprising to the upside. But I’ve got to begin to plan for the day when Chinese expansion eventually surprises computer modelers on the downside. Thanks to Mr. Babones, however, I’ve got plenty of time to ponder what I’ll do.

two tricks of performance calculation arithmetic

August 19, 2011 By dduane in Absolute vs. relative performance, Analyzing performance, Constructing a Portfolio, Current Market Thoughts, Portfolio management, Recent Market Action, Trading Tags: Accounting, Current Market Tactics, finance, investing, investment performance, performance attribution, Portfolio management, stock market, Trading Leave a comment

measuring performance

The acid test of active management–both of our own efforts and of the professionals we may hire to invest for us–is whether they add value versus an appropriate index. Picking the benchmark against which to measure results is a pretty straightforward task, though judgment issues do sometimes arise. (For example, if all a manager’s outperformance of the S&P 500 over the past three years comes from holding a large position in Baidu (BIDU), the Chinese internet company listed on NASDAQ, is the S&P really the right index to be using? But that’s a story for another post.)

What I want to point out here is a quirk in the way performance calculations are done:

–in a rising market, outperformance tends to look better than it really is;

–in a falling market, outperformance tends to look worse than it really is.

The opposite is true of underperformance.

—in a rising market, underperformance tends to look worse than it really is;

–in a falling market, underperformance tends to look better than it really is.

Here’s what I mean:

Let’s take an example where the numbers are impossibly large, just to illustrate the point.

outperformance

We’ll suppose that on Day 1 of the measurement period the index is unchanged but our portfolio gains 50%. At the end of Day 1 we’re 50 percentage points ahead of the index.

a. rising market. Suppose that for the rest of the year, our portfolio matches the market performance exactly and that the index doubles from Day 2 through the rest of the year. How far ahead of the index is our portfolio for the year?

Your first instinct is probably to say “50 percentage points,” since we’ve made no further gains after Day 1 …but that’s wrong. The actual outperformance is 100 percentage points.

If the index starts the year at 100, its ending value is 200.

If our portfolio starts the year at 100, we’re at 150 at the end of Day 1 and we double from there–meaning we’re at 300 on the final day, or 100 percentage points ahead of the market. Whatever positive thing we did on Day 1 has been magnified by the rising market.

b. falling market. Let’s take the same portfolio, up 50% in a flat market on Day 1. This time, let’s suppose our portfolio matches the index for the rest of the year, but that the index falls by 50% between Day 2 and the end. How far ahead are we for the year?

Having seen a., you’re already going to guess that 50 percentage points is wrong. …and 50 is wrong. But what’s the right number?

Well, if the index starts at 100 and loses 50%, at the end of the year it’s at 50. At the end of Day 1, we’re at 150, but we lose half that amount through yearend. So we end up at 75, or 25 percentage points ahead of the index.

underperformance

Let’s start again with crazy numbers. Assume Day 1 is the day from hell and we lose half our money in a flat market. We’re 50 percentage points behind the index.

c. rising market. The market doubles from Day 2, going from 100 to 200 by yearend. We match the market. Our 50 goes to 100. We’re 100 percentage points behind the market.

d. falling market. The market declines from Day 2 on, and drops from 100 to 50 by yearend. Our 50 is cut in half to 25. We’re 25 percentage points behind the market.

implications

There are all sorts of implications for professional investors, who tend to earn most of their compensation based on annual performance vs. an index. You never want to get behind in a rising market, for instance. Or, a falling market tends to compress out- and underperformance numbers closer to the index, so that’s the best time to play catch-up.

For the rest of us, the lessons are:

–don’t get too excited about the “phantom” outperformance that a rising market (2009, 2010) brings, and

–more important, a decline of 15% like the one we’ve been in will reduce your under- or outperformance by 15%. Don’t think your stocks are suddenly doing better/worse than they are. To see your real performance during the downturn, don’t check the year to date figures, check them from the start of the downturn until now.

NOTE: If you’ve constructed a portfolio for a rising market, or if you were ahead year to date before the current decline began, you should expect some slippage in relative performance as the market sags. Similarly, if your holdings are geared for a down market, you should now be seeing a pickup in relative performance.

How much relative gain or loss? That’s another post-full. A lot depends on the level of risk you’ve assumed and your skill in picking stocks. But if you’ve battened down the hatches, you should be seeing at least some benefit. If you’ve continued to keep a lot of sail let out (which is my usual position), you shouldn’t be surprised/dismayed by a modest relative loss.