The Investment Scientist

Archive for May 2007

price chart downOn a recent air trip to China, I found myself sitting next to a Japanese. As our conversation turned to real estate, I opined that the Japanese real estate market had finally turned the corner after 16 years of falling prices, and it might be a good time to buy. He immediately disagreed with and went on to give me a litany of reasons why the Japanese real estate prices would keep on falling. His reasons include that no Japanese nowadays would think that the real estate prices will ever go up again.

In 1991 when the Japanese market was at its peak, banks were lending to home buyers without any down payments, people were taking out interest only loans, and everybody was expecting the real estate prices, already the most pricey in the world, to keep on rising. Does that sound familiar? Was it like what we saw two years ago in some hot markets in the US?

The excess in their real estate market took the Japanese 16 years to unwind. During this time, their real estate prices fell by an average of 60%. Counting inflation, real values have fallen by more than 80%.

Could the US real estate market experience a long recession like what had happened in Japan? I can’t give a definite answer. However, judging by how relatively optimistic people are with real estate, I believe there is still a long way to go before the market turns around. I think when I don’t see real estate investors around me, when I don’t see people talking about real estates as the best investment, better yet, when I see people in the US speak like the Japanese I met on the trip, I can then reasonably conclude the bottom has been reached.

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The title is a question posted to me by email, and the following is my answer.

In 2003, for a very short period of time, I achieved that type of return.

That was when Sarbane-Oxley Act went into implementation w.r.t. insider trading reporting. Before the implementation, company insiders (CEO, COO, CFO etc) had two month time to report their inside trades, and by paper; after the implementation, they had to report within two days electronically. At that time, I created a program to query the SEC insider trade database. As a result, I was able to follow the insider purchases as soon as they were reported. One or two weeks later, when the insider purchase news hit the wire (Dow Jones or Wall Street Journal), the stock prices would jump and I would exit with a tidy profit. At one point, I was making 30% monthly returns. In less than 6 months however, websites were popping up left and right offering real-time insider trading information, and my strategy became obsolete.

The point I want to make is: if there is a way to make 10% monthly return, it won’t last very long if there is no barrier of entry. That’s why in my current investment management practice, I do something others can not easily mimic.

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On May 13th, the Shanghai Stock Exchange Composite Index (SSEC) for the first time crossed the 4000 level. In just this February, when the index crossed the 3000 level for the first time, it promptly dropped 9%, causing a worldwide correction in stock prices. Who would have thought, in the short 3 months that followed, it would have crossed another milestone.

Indeed the whole country of China is swept into stock investment hysteria. By the end of April, there were 96 million brokerage accounts in the country, three times the number there were last April. New brokerage accounts are opened at the rate of 1 million every 3 days. If you get into a taxi in Beijing or Shanghai, you will likely get a free lecture on stock investment along with the ride; street vendors will offer you free stock tips as you shop and even grandmas and grandpas can’t resist dabbling in and out of stocks with their life savings. (The picture below is a grandpa before a screen of stock prices. The coloring convention is the opposite of the US. Red means profits and green means losses.)


Miracle stories abound as well. There are the usual overnight success stories of somebody (names published in newspaper) who made over a million dollar in one day. There are even stories of chronically sick patients who recovered after winning big in the market.

These anecdotal stories of mania are worrisome enough, they are further corroborated by the unsustainable high average P/E ratio of over 50 in the Chinese stock market.

That’s why I see dark clouds gathering even while many people still see green. Stock market crashes of significant magnitude (> 40%) are never caused by economic problems alone, they are usually preceded by a period of unbridled optimism. The optimism in China now is at a hysterical level and it is unlikely to abate leading up to the 2008 Olympics. What I am afraid will happen is that after the 2008 Olympics or shortly before that, smart money will exit the market. A massive exit could trigger a run in the Chinese market that would spread globally.

What can we in the US do about it? First, don’t panic. The ship that is the US financial system is very solid and resilient, storms (even one coming out of China) will shake it but will not sink it. Second, it would be prudent to raise the cash level of your investment leading up to the Olympics. In case you don’t know, the opening ceremony will be on 8/8/2008, still 445 days away. Third, it is wise to invest in defensive stocks.

As a matter of fact, it is always wise to invest passively.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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