August 27th, 2015
by Jeff Miller, A Dash of Insight
The latest story scaring investors witless (TM OldProf Euphemism) is the collapse of the Chinese economy. It has become an element of Wall Street Truthiness. The Chinese are lying about their data, masking the true story. "All of the data" support this according to the commentators, led by pundit-in-chief Jim Cramer and the rest of the gang at CNBC.
How about some much-needed objectivity?
A Primer on Chinese Economic Data
The key sources are varied, and with quite different conclusions.
China is attempting to switch from an export economy to one with more emphasis on the consumer. This means less manufacturing and more services. This widely-publicized policy shift is crucial in finding the best data sources.
There is widespread skepticism about the official GDP reports that the current target, a 7% increase in GDP, is being met. Most observers think that the Communist leadership fears retribution and might lie about the data. (Regular readers know that I have frequently joined in this viewpoint).
When little information is available, markets seize (and perhaps exaggerate) whatever is available. Recent market moves - including very large ones - have been attributed to China news. This has filtered into the popular media. Frightened investors sold mutual funds, contributing to massive "market-on-close" orders today - ten times the normal imbalance. (Mutual funds cash out investors at their closing NAV. Selling their holdings at the close guarantees that there will be no discrepancy between the price the get for selling stocks and what they pay the redeeming investors).
Pundits are required to "explain" each day's trading. The wild swings in the Chinese stock market provide an easy hook. They then follow by saying that the Chinese economy is the second largest (based upon official data, of course) and might drag down everyone else.
One way of evaluating Chinese economic growth is to monitor power consumption. For many years it has provided independent confirmation of the official claims.
- The bearish take is the decline in power usage. The Christian Science Monitor notes that the increase in this indicator is only 3.8% and also has good general background.
- An alternative viewpoint suggests that the data simply reflect the shift from manufacturing (power-intensive) to other sectors. (Official China Source).
The Markit Flash PMI Indicator
This economic report is gaining a lot of traction, mostly filling a data vacuum.
There are actually two different Chinese PMI indicators.
The "official" version comes from the largest enterprises, which are mostly state-owned. The Caixin version replaced the HSBC method about a year ago. It is conducted by Markit, which is trying to establish a comparable PMI method around the world.
If you already feel confused, get ready for more. The Markit survey has a "preliminary flash" version based upon partial returns. It is this version that caused the big stir last week.
Characteristics of the PMI Index
Hardly anyone understands the nature of these reports, so there is plenty of misinformation. Here are some key points:
- It is a diffusion index. It is not an absolute measure of strength, but a comparison with the prior month. This means that if you were driving 80 MPH last month and 75 this month, it is counted as contraction. (Or vice-versa).
- It covers manufacturing in a certain subset of companies, perhaps not capturing the most recent Chinese policy shifts.
- When launching a new data source, it is helpful to have a long history. This permits comparison with important dependent variables. This survey started in 2003.
- It is a survey. There are 400-500 respondents. We are assuming the following:
- The sample was well-chosen
- The response rate (not reported) was adequate
- There was no bias the companies of early respondents
- The responders are honest, with no influence or pressure
- Assuming all of the above, there is still sampling error. In an excellent survey with this sample size it would be about 4-5%.
- And of course, it is the "preliminary" version, meaning that a final version will include more respondents.
Pundits embrace data that confirms their biases.
In the last two days we have had multiple reports by companies that actually do business in China. The data reported do not depend upon a Communist government's biases. Anything said can either be immediately confirmed by official US filings, or soon will be. I watch for this information like a hawk, scrolling back on TIVO to get the full story.
- Apple Computer. CEO Tim Cook reports that business has never been better in the Chinese Apple stores and that new connections are at a record rate. (I know that deniers want to attack him for saying this, but we will all know soon whether or not he lied. Do you really think so?) This is confirmation of the consumer demand.
- BHP Biliton CEO Andrew Mackenzie stated on CNBC that internal data confirmed the official claims of 7% growth. He quietly and patiently explained to a skeptical and aggressive Cramer that they had been trading with China for 20 years. Their internal indicators worked just fine in past periods and showed 7% growth right now. He cited supply-chain evidence. See the full interview.
- DHL CEO Stephen Fenwick made similar comments in his interview, saying that business in China was good and fears were overblown.
Choosing Among the Sources
I am not an expert on everything, and neither are you. I take pride in doing research to find the best sources on each subject. It is a shame that the "instant experts" on China are not required to take a small test. How many of them could tell you anything about the Markit version of the PMI? If you read this article, you already know a lot more than Cramer, who misleads people daily on this topic.
In addition, and as I have carefully written, the Chinese economy is not that critical for most US companies. Recessions do not start from "stalls" but from real business cycle peaks.
For investors to succeed they need to find a successful plan and stick with it. My own approach, embraced by many great value investors, is to find excellent companies that generate solid earnings and dividends. Sometimes the market disagrees with our estimate of earnings potential, so the stocks go "on sale." In the last week I have watched plenty of great companies sold as part of program or ETF trades. Or out of fear.
This is a normal part of the process for a long-term investor. I have an email file labeled "fear peddlers" where I file daily messages from a variety of sources. Some of them are quoting Warren Buffett's two rules:
- Don't lose money.
- Don't forget rule #1.
Mr. Buffett's stock positions frequently show mark-to-market losses. Part of the reason that Mr. Buffett does not lose is in the long run is that his decisions are based upon the value of his holdings, not the current market price. He does not sell unless the price is attractive.
Investors who do not have a plan, or do not understand what they own, should feel free to sell. Those who have a solid value program should accept the market fluctuations, perhaps buying a little more if their personal circumstances warrant.
The current irrationality about China presents such an opportunity. I am emphasizing great stocks that have nothing to do with China. My next tier of choices will include some direct exposure (so far, only a touch in our "high octane" program).