Dear Paul,

Recently, Former Federal Reserve Chairman, Alan Greenspan, suggested that there was a “stock market bubble” in China and that it was “clearly unsustainable.” 

How is Foxhall Capital preparing to manage risk if the Chinese stock markets have a severe correction?

Former Fed Chairman Alan Greenspan said the current rally in Chinese stocks is “clearly unsustainable” and “there’s going to be a dramatic correction at some point.”

While I agree with his assessment, the timing remains uncertain. It helps to remember that Greenspan’s 1996 pronouncement of “irrational exuberance”  in US markets preceded the stock market peak by more than three years.

To give you some background, Greenspan was only speaking of the Shanghai Stock Exchange and China’s domestic A-Share stock market that can only be invested in directly by Chinese citizens.

The Shanghai A-Share Index has more than quadrupled over the last 18 months and is still accelerating despite repeated warnings from the Chinese Government.

It should be noted that the 25 largest Chinese stocks traded here in the US are flat year-to-date, although they are up about 50% over the past twelve months.

(Source: iShares China 25 Fund 5/29/07)

Overall, Chinese companies continue to benefit from strong sales, earnings growth, low interest rates and real GDP growth in excess of 10% since 2004.

It has been reported that over 1 million new brokerage accounts are being opened every day by inexperienced Chinese retail investors. That alone should cause concern. There is definitely a stock market bubble developing.

WHEN WILL THE BUBBLE BURST? 

The MSCI Chinese A Share Index is up 106% year-to date as of May 29th. It is up over 212% for the trailing 12 months.

The big question is, when will it end? The NASDAQ tech bubble in the late 1990’s lasted for 3 years, so there may still be some upside for Chinese stocks before a major correction. Last week the Chinese government tried to cool the growth in the market by tripling fees for buying and selling stocks. The market declined the next day by 6% and then started to recover the day after.

If the market continues to climb, the Chinese government will implement other measures to make the market less attractive to new Chinese investors.

At Foxhall Capital, we never try to anticipate when something will happen in a stock market, we simply follow the market in the direction it is already going and when there is a major correction we will take defensive actions to manage risk in our client’s portfolios.

We continue to watch the Chinese markets carefully.

FOXHALL CAPITAL MANAGES RISK

Foxhall Capital is managing risk by diversifying all of our Pacific Rim investments to broad regional index funds that invest in all of Asia and not just in China. We also have about 10% of our equity portfolios invested in hard assets like gold, oil and precious metals that have historically outperformed when stock markets decline.

It helps to remember that China is only 1% of global market capitalization versus 35% for the US, so even a large decline in Chinese stocks would not necessarily have a debilitating impact on the rest of the world. (Source: The Week, Wachovia Securities 5/29/07)

It also helps to remember that the Chinese A-Share stock market dropped -9% in late

February and then bounced back in less than a month and then went on to new record highs. Other Asian markets dropped on average about -3% and have since recovered and moved to new highs.

The Chinese economy is still the fastest growing economy in the world and that is not going to change anytime soon. Emerging stock markets like China can sometimes be a wild ride, but if you have patience, a disciplined investment strategy and active risk management controls-the growth is well worth the bumpy ride.

S&P 500 INDEX HITS NEW HIGH 

This week, after almost seven years, the S&P 500 INDEX broke through its March 2000 high to set a new record. I will talk about this event in our next newsletter.

Until next week….

-Paul Dietrich

dietrich@foxhallcapital.com

800-416-2053