Cooling off the Market

Robert Hsu, May 05, 2008

Throughout 2007 the Chinese government has taken steps to cool off the booming Chinese market. One such step occurred at the end of May last year when the government tripled the trading tax, or more commonly referred to as the stamp tax. At that time, the stamp tax was bumped from 0.1% to 0.3%, with the government's intention to curb speculative mania in Shanghai stocks.

Let's briefly review what it is and why it's important. Unlike the United States, China doesn't inflict capital gains taxes on investors' trading profits. Instead, Chinese investors are charged a stamp tax on every trade and the revenues from this tax go to the Chinese government.

The stamp tax has been around for 17 years, and when it was enacted in October 1991 was set at 0.3% per trade. Over the years, the tax fluctuated as low as 0.2% and as high as 0.5% until China's bear market in 2005 when the stamp tax was bumped down to 0.1%.

Now a year later, the Mainland Chinese stock market bubble has deflated, experiencing a 50% correction from October highs. So the Chinese government wants to help support the market, and has taken the first step by announcing this week that it is lowering the stamp tax back to 0.1% per trade. In response to the announcement, the Shanghai stock market rallied 14% just in the past two days.

This is a very bullish sign for our investments. Although we don't, and can't, directly invest in the Shanghai stock market, we're still going to benefit from the stamp tax reduction and the move up in Shanghai stocks. How? The strong performance in Mainland Chinese stocks helps the psychology in our stocks. This is especially true now that Chinese stocks and ADRs in Hong Kong and New York are trading at attractive valuations again.

The interesting thing about all of this is that while I was in Beijing a few weeks ago, I was interviewed by a senior reporter from China Financial Times, the leading financial newspaper in the country. During the interview at the Shangri La Hotel, the reporter asked about my current market outlook. I basically told him what I've been telling you for months now. I said that I thought Mainland Chinese stocks listed in Hong Kong and New York would move up, U.S. stocks would be stuck in a trading range, and Mainland Chinese stocks listed in Shanghai had more downside.

My reasons were straightforward.

Hong Kong and New York: As you know, stock prices are determined by a combination of earnings growth, interest rate trends and valuation. Chinese stocks listed on the Hong Kong exchange and their ADRs that are traded on the New York Stock Exchange have strong earnings growth, interest rates in both Hong Kong and the U.S. are very low, and the index of Mainland companies in Hong Kong is trading at only 14 times 2008 earnings. So after the mandatory washout of speculative excess that has occurred in these stocks in late 2007 and early 2008, they have all three fundamental factors going for them and are attractive buys again.

United States: On the other hand, U.S. stocks have two of three fundamental factors in their favor. They have lousy earnings growth, but interest rates are low and valuation -- at 15 times 2008 earnings for the S&P 500 -- is reasonable. Therefore, I think the U.S. market will continue to trade in a 10% range and could possibly end the year not far from where it started.

Mainland China: Companies listed on the Mainland Chinese stock market have only one of the three fundamental factors on their side. These stocks have decent earnings growth, though it's not nearly as strong as the Chinese companies listed overseas. But unlike Hong Kong and the U.S., Beijing has hiked interest rates six times last year and pursues a tight monetary policy to combat inflation. And the Shanghai stock market is also 60% more expensive, trading at 22 times 2008 earnings. That's why I thought Shanghai had more downside.

Now this is what was so interesting about this interview and how it ties back to the stamp tax. After discussing my market outlooks for Hong Kong, the U.S. and Mainland China, the reported asked me how the Chinese government could support the market to give it more upside potential. First, I pointed out that Beijing's job is not to support the market. But now that the Mainland Chinese stock market bubble has deflated, the government can undo its efforts from last year to control the bubble. My recommendation to do this: Drop the stamp tax back down to 0.1%.

Isn't it funny how things played out exactly as I predicted?

Hong Kong-listed Chinese stocks soared 15% in the past three weeks.
The S&P 500 is still trading at levels from the beginning of April.
And Chinese stocks in Shanghai sold off to new multi-quarter lows recently. But then the Beijing government acted in the way that I thought it should, and stocks in Mainland China moved up sharply.

With the lowered stamp tax changing the psychology in Shanghai, I am very bullish on Chinese stocks that are trading in Hong Kong and New York, because there is nothing to really hold them back.

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