Chinese Stocks Still in Trouble

One analyst sees worse to come.

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Investors should note the speed at which last year's hottest stock market became a pariah.

The Shanghai Composite index trades around 2500 today, almost 60 percent below a peak above 6100 reached last October before inflation became a severe worry and the U.S.-led slowdown in the global economy grew more widespread.

Donald Straszheim, vice chairman at Roth Capital Partners and a longtime China watcher, sees "significant negatives" in the near term, as even China's Olympic moment failed to cheer traders.

Here's why he sees China going lower:

Non-tradable shares overhang the market. Following the fundamental equity reforms on China's all-important state-owned enterprises in 2005-06, a major overhang of shares are being unlocked for sale in the markets. This unlocking is largely centered from mid-2008 to mid-2009. Issued when the market index was about 1000, then subsequently running to 6000 and now under 2500, many of these shares are likely to be sold into the market during the coming months—a major negative for equity investors.

China ' s economy is slowing.We expect Beijing to report real GDP in the 9.0-9.5% range for 2008Q3, extending the slowdown from the 11.9% reported in 2007, and the 10.6% of 2008 Q1 and 10.1% Q2. Inspecting the data in China's industrial production, fixed asset investment and export sectors, the GDP report looks to us like the slowdown is even more pronounced. There is downside risk here.

Global weakness as well. The global economic and financial environment also looks to be weakening over the near term, with the US, EU and Japan all in or near recession.As a more international economy, China's markets are more likely to move with—than against—other key global markets.

Inflation in China is too high. Inflation in China is still too high, with the latest PPI at 10.0% year ago, and the CPI at 6.1%. China's anti-inflation efforts have not worked.Price controls on energy and food have caused more harm than good. Skepticism is growing about Beijing's ability to manage inflation in a global setting.

Inflation worldwide is also too high and rising. Inflation is too high in most of the developed and developing world. And the developed economies are fighting financial meltdowns, putting inflation fighting down on the priority list.

Profit growth is contracting. The profit slowdown is being fueled by slower growth, higher energy and other commodity prices, rising wages, and weaker markets overseas sharply eroding China's export sector. Earnings in the first 5 months of 2008 were +21% versus +42% in 2007. We see earnings up about 15% in 2008, versus gains in the 30-45% for most sectors in 2006 and 2007. 2009 earnings look no stronger than 2008. Huge distortions in the energy sector caused by domestic price controls have hurt profits as well.

Cross-holding earnings also slowing. Cross holdings are important in China as they are in most emerging markets. They were a massive plus in 2007 as equities ran from 2000 to 6000. They will be a major minus in 2008 as equities have retraced much of their earlier advance.

" Policy " support from Beijing has proven ineffective. Beijing and the CSRC (China Securities Regulatory Commission) explicitly desire a rising market—favorable to keep doing IPOs of state-owned enterprises. But the public has understandably become skeptical (understandably) of the government's ability to manage the market and deliver this upward slant. They did lower the stamp duty tax early in 2008—it was among the highest in the world. nd the CSRC put out the word for fund managers to not speak negatively of the market during the Olympics. That guidance has been followed, but equities have plunged. So much for guidance.

My take: If you look at the list above, note the points that also apply to U.S. markets. Rising inflation, both at home and globally? Lower profit growth? Global weakness and a slowing economy at home? Ineffective policy support? It all sounds eerily familiar, plus we've still got that banking crisis to worry about.

Maybe we should be glad the Dow and the S&P are down only about 13 percent year over year.