China's economic growth rate has been nothing short of spectacular.  While in 1963 China was the 12^thpoorest country in the world per capita, lying between Somalia and Burundi in the rankings, by 2012 China is in the middle of the economic pile.  China emerged from a centuries-long slump, but it wasn't without the exercise of State power.  While many State programs were epic failures (e.g., the Great Leap Forward), many more have been successful (e.g., the development of high speed railways and transportation networks and the most prolific industrial and manufacturing base on the planet).

I bring up State power because in China the State has directed many immensely beneficial projects, and there are indications that the State may be now serious about developing the equity markets to international standards.

Social media has been fairly positive on China generally over the past three years, but the trend is down.  Optimism (future-looking sentiment) about China expressed in social media, while well above the U.S. and Eurozone, is essentially on par with Japan and is lower than South Korea.  See figure below:

In our quantitative studies with Optimism and Equity sectors and industries, we find that changes in Optimism are usually more significant in their impact than the net level.  In the example above, the decline in Chinese Optimism reflects the decline in Chinese share prices. As we continue to study sentiment indices and national economic development and stock market returns, we will explain more of what our findings mean for the future.

In another study (not displayed) we found that Fear about China is quite high, second to the Eurozone of the nations and regions listed above (see chart below).  

That is, there is significant anxiety expressed in English language social media about China.  Despite overall Optimism about China's future, this is tempered by Fear that China's rise comes with risks.

When we analyze currency price forecasts, we see that the consensus for China's Yuan is that it will rise, although the consensus has begun to unravel in the past year (see chart below, note that the colors denoting each country changed).  The Yuan revaluation consensus is falling as it becomes clear that Chinese inflation is reducing some industrial competitive advantages, and money is moving out of China, as wealthy investors and successful companies sell Yuan to buy overseas assets.

What does the consensus mean for us?  First, when we've had a long period of extreme consensus in the markets, and the consensus begins to shift, it takes time for investors to readjust their expectations and for the new reality is reflected in prices.

Being contrarian by nature, I tend to believe that the consensus is priced in.  But being an empirical being, I've tried to prove this statistically.  We've done some quick studies on whether future expectations can predict prices.  We find that large short-term changes in future expectations have a lagged impact and do often precede price changes.  This finding is only true for social media.  News tends to report the safe opinion, which is usually an extrapolation of what already happened, while social media is more useful in our research.

Since 2007 the Chinese stock market has been in a slump.  We predicted as far back as 2000 that there would be a massive "Buy on the Rumor, Sell on the News" pattern around the Beijing Olympics with Chinese indexes rising into summer 2008 and then falling after the Games were held.  Our timing was off (by a year!), but the general pattern held.  The markets recently hit three-year lows (before rebounding 10% the first two weeks of December).

The China Securities Regulatory Commission (CSRC) indicated on November 30, 2012 that a stable stock market is in the national interest.  And we know from recent history that when the Chinese government sets a goal, it usually achieves it.  There is also some momentum behind reforms of the Chinese financial markets.  We're seeing historically low Chinese stock valuations (P/E ratios), the emergence of Chinese financial products such as mutual funds, Chinese real estate prices plateauing, and some world-changing companies emerging out of China. 

Is it time to get back into Chinese stocks? 

Ah, but of course there is always a contrary opinion.  Many local and international investors are worried about the high levels of state ownership of shares (as this excellent article explains).  There is an unresolved conflict between U.S. accounting rules and the requirement of U.S.-listed State-owned Chinese ADRs to reveal their internal numbers (which are State secrets per Chinese law).   And don't forget that many U.S.-listed Chinese stocks had fraudulent accounting detected by our social media Alerts in our June 2011 newsletter.  Bank stocks have low P/Es due to an accumulation of non-performing politically-motivated loans, and when they are removed from the Shanghai index, P/E ratios are actually fairly high - above 20.

Given the weight of the evidence, I think China may be forming a bottom around 2,000, and from here we're likely to see positive reforms to root our fraud and fix a broken equities market.  So is it time to buy?  As in every situation, one must look carefully for the companies of the future and select carefully.

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