China stocks: possible correction ahead – continue to buy!

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Since the middle of May I am on record for being bullish on Chinese stocks. One of the top Chinese managers, Liu Yang, chairwoman of Atlantis Investment Management echoed my bullish view in an interview with Bloomberg on Monday, July 11. She has been negative on Chinese stocks since the end of last year but thinks these stocks offer value and are in for a significant rally despite all the concerns about debt globally.

But just why is Yang so bullish?

I think the two of us are on the same wavelength because she is clearly aware of the relationship between the Chinese stock market and the CFLP manufacturing PMI. She is obviously expecting the CFLP manufacturing PMI to rise in the near future from 50.9 in June.

Sources: CFLP; Li & Fung; I-Net; Plexus Asset Management.

But, as in the case of the Bloomberg interviewers, you may question her bullishness about China’s manufacturing sector. As the manufacturing PMI fell for the third consecutive month in June this must surely be an indication of not only a weaker Chinese economy but also evidence of a weakening global economy. As things stand with the default concerns in the Eurozone and weakness, and especially on the job front in the U.S., the outlook is not bright at all. Not so?

Yes, without any further research that will be Yang’s and my first take. There is another major factor in China’s economy and specially the manufacturing sector that should not be ignored. Seasonality!

The seasonal pattern in China’s CFLP manufacturing PMI is clearly evident in the following graph where the monthly PMIs since 2005 are depicted. Please note that 2008 and 2009 have been omitted as patterns were disturbed as a result of the global liquidity crisis.

Sources: CFLP; Li & Fung; I-Net; Plexus Asset Management.

My computed seasonal trend has a narrow relationship with the Shanghai Composite Index. It can therefore be expected that the Chinese stock market will rally through end September and that a level of 3200 is achievable – nearly 15% from today’s closing level of 2787!

Sources: CFLP; Li & Fung; I-Net; Plexus Asset Management.

But is the relative weakness of the CFLP manufacturing PMI since March not a clear sign that China’s manufacturing sector is in distress? To some extent, yes, but to me Japan’s twin disasters played a major role. It is particularly evident if I seasonally adjust the CFLP manufacturing PMI and compare it with Markit’s Japan manufacturing PMI.

Sources: CFLP; Li & Fung; Markit; Plexus Asset Management.

My only concern is that China’s stock market has run ahead of itself as it is anticipating a jump in the PMI to in excess of 52 compared to June’s 50.9. July is normally a very weak month from a seasonality perspective and I will not discard the possibility that the Shanghai Composite Index could retreat again to the 2650 level. But the million dollar question is what if Japan’s recovery gains further momentum, pulling along China’s manufacturing PMI? In that case the Chinese stock market is aptly priced and we have therefore seen the lows, unless another black swan arrives.

China’s economy grew by 9.5% in the second quarter on a year-ago basis. This was ahead of my expectation of 9.2%.

Sources: CFLP; Li & Fung; I-Net; Plexus Asset Management.

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