My Comments: It’s fascinating to watch the changing dynamic of China as an economic power, moving inexorably toward a form of democracy, driven by an emerging middle class that is clearly starting to express an interest in the rewards of a “good life”, while at the same time experiencing the political pressures that dictate how those economic forces are going to play out.

But play out they will and in all probability, perhaps long after you and I are gone, there will be a nation that takes its place in the world and expresses its leadership in a manner not unlike we as the United States expresses itself. If I have one regret, its that I wont be here fifty years from now to see how it all happens.

by Jeffrey Dow Jones

One of my themes to watch in 2012 was China. I thought this was going to be a very important year for China, one that generates a lot of debate and dialog. So far, I’d say that this has been mostly correct. Maybe not in terms of the ubiquity and size of the Chinese discussion, but definitely the different dimension.

In case you’re still thinking of China as this rapidly industrializing, cheap-exporting, exponentially growing awesome economy that will soon be kicking the United States to the curb and stealing its lunch money, it’s time to stop living in 2007 and wake up in 2012. The vector has changed.

Bloomberg Businessweek did a great article on this last week. Giving it a read should get you quickly up to speed on the broader points, especially about why all the drama around Bo Xilai matters for economics.

I can’t tell you how fascinating the evolution of this economic story has been to me. Five years ago, I think the word “insecure” accurately summed up the way the U.S. felt about China. That was the context for the discussion back then. Today, however, we’re a lot less worried about what being the #2 economy means — why does it matter if the largest economy in the world is still a very poor nation? — and instead we are nervous that China slowing down may take us with them. Can’t have that, now. No, sir.

There’s also a newer, stronger component of moral superiority to the debate. Open up the Wall Street Journal and you are repeatedly exposed to commentary about how a “proper” economy ought to be run. Turn on MSNBC and you get a steady stream of human rights stories with China as the main villain.

If you want to take a deeper look at the economic angle and you can clear your schedule for the afternoon, I’ll recommend Hugh Hendry’s latest epic commentary. Hendry runs the Eclectica fund and I used to follow his stuff religiously until he stopped writing and kinda disappeared. This is his first published research since 2010.

In any case, the essence of his argument is that China is speeding towards disaster. I’ve spent a lot of time in this newsletter about negative real interest rates here in this country and the perverse incentives that disquilibria like that can create. But in China the financial repression is far worse and has persisted for much longer. With inflation that usually runs between 7-9% per year and a government-imposed cap of 0.72% on bank deposits, savers in China (a nation that really likes to save, too) is forced to deal with negative real rates of -7%. With that kind of disincentive to save, nobody should wonder why they have a pretty spectacular real estate bubble over there.

For the most part, businesses and investors remain optimistic on China:

Sentiment is high. But I can tell you one thing about investment sentiment in general: it’s correct right up until it’s too late to matter. Sentiment changes after pain, not before. It’s a lagging indicator, not a leading one. If you’re interested in avoiding pain connected to with a flailing (failing?) Chinese economy, tracking measures of sentiment won’t help you.

That’s why the other data from that survey is so interesting. It showed that over 70% of these U.S. companies surveyed reporting that China’s regulatory environment is the same or getting worse and 90% that say China is losing competitiveness because of rising costs. Concern about an economic slowdown also rose significantly between 2011 and 2012. So there’s a bit of a contradiction in this data.

Perhaps it’s just a case of people still being optimistic, only less so. That’s not always indicative of disaster. Though it can be the first step on a slide towards it.

The stock market, on the other hand, is a lot more clear.

It’s worried: That’s not a healthy chart. Even if you masked the name of it, I wouldn’t want to buy that asset. It’s a classic chart pattern: bubble, burst, bounce, followed by slow-disintegration.

It has taken a while for this trend to really become clear, so you can see why the pre-bubble China narrative persisted in the mainstream until around the end of last year. Being so fixated on Europe in 2010 and 2011 made it that much more difficult to worry about what was happening in the Far East. Now that we have a better grip on what life ahead for Europe will look like and what it means for the markets, we can turn our attention elsewhere. Just in time to tune into a slowing Chinese economy.

I saw thousands of those charts in the wake of the tech bubble. Most of those charts have no future. They end in bankruptcy or a take-out. As an investor, you want no part of them. You keep hoping that someday, maaaybe, they’ll get back to those old highs but they never do. The old highs were an illusion, an inflated multiple.

Every once in a while, if the asset in question is a large and important company, they just take time to finally grow into their multiple.
Intel is a textbook example of this:

In this example the asset is finally trending in the right direction, making new highs, and doing it from very sensible valuations. Intel pays a 3% dividend and trades at under 12x earnings. (Full disclosure: I do not own it.)

China won’t go bankrupt or disappear the way that a crappy company can. Its chart will someday turn back around. The question is how long. Will the Chinese economy become an investment with a fair multiple and acceptable growth prospects in a few years? Or will the investment’s struggles drag out for decades like Japan?

The truth is I don’t know enough about China. I don’t have the answers. Because of my role in the industry and because I consume a way-above-average quantity of financial news and commentary, I might know a little more about it than Joe Shlabotnik on the street. But I honestly don’t know enough about it to speak with certainty and authority. The reality is that very few actually do.

Hendry’s probably more qualified than most — I was reading his research on China years ago — and he’s done fairly extensive travel through the country. In fact, it was from him and his goofy YouTube videos that I learned of all the Chinese “ghost cities” in the first place. Bloomberg wouldn’t do their groundbreaking story on that until about a year later.

But I do know one thing about economies in general, especially the large ones. I know that they are impossible to control. Managed economies inevitably fail. This was perhaps one of the greatest economic lessons of the 20th century. The ones that appear to be working like Soviet-era Russia or the old East Germany are always revealed to have been an illusion when the curtain comes down.

Part of me wonders if, in five or ten years, we look back at China and crack up with laughter. “Trying to manage their economy! Ha! What were they thinking??”

I know that China’s economy isn’t completely managed, but it is something of hybrid. It’s sorta free, but not really.

As an investment, my beef with China is the same as my beef with Bank of America, Societe Generale, or pre-2010 Greece: they tell me that their financial condition looks one way, but I simply cannot trust it. Perhaps that’s just my hyper-skeptical Gen-X nature. Perhaps it’s because I’ve been burned one too many times in the past. I know deep in my gut that it is in their every interest to make themselves appear as awesome as possible, even if it means playing fast and loose with FASB guidelines or flat-out lying. Given the complexity of their financial situations and a track record of obfuscation, I cannot bring myself to buy what they are selling.