A Strong Case for a Bubble

Posted by Jamie Switzer and Marc Latta of Raymond James

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Market Summaries as of May 28th/2010

S&P/TSX Composite up 1.30% to 11671 (down 0.60% year-to-date)
S&P/TSX Venture Composite up 3.44% to 1502 (up 4.39% ytd)
Dow Jones Industrial Avg down 0.60% to 10137 (down 2.80% ytd)
Nasdaq Composite up 1.30% to 2257 (down 0.50% ytd)
Oil (West Texas Intermediate) up $5.93 to $73.97 (down $5.39 ytd)
Gold (Spot USD/oz) up $37.28 to $1214.38 (up $117.43 ytd)

Is China’s Real Estate Market the Next Bubble?

A strong case can be made that China’s real estate market may be reaching bubble territory. When asset values are not at extremes, it is much more difficult to forecast their future behaviour. In contrast, the more dramatic the extremes in any given situation, the easier it becomes to determine possible outcomes. Any asset class which is either wildly undervalued or overvalued is far more predictable than any asset class which does not act in this manner.

There are many theories about what is going to happen with China. One camp insists that the Chinese government will soon allow its currency, the renminbi (or Chinese yuan) to float freely similar to other world currencies instead of being pegged to the U.S. dollar. A very large group of analysts believes that indefinitely rising Chinese demand, combined with indefinitely improving economic conditions, will not only enable China’s total GDP to exceed that of the U.S. and every other world country, but will also put powerful upward pressure on equity and commodity prices around the world. Still others are convinced that China will increasingly use its heavy investments in assets such as US Treasuries to put economic pressure on a global basis to suit its geopolitical ambitions.

Perhaps what is being overlooked is the exact same issue that hurt Japan in the 1980s and in most developed countries including the United States four years ago? Evidence suggests that China’s real estate market could be in a bubble. It was highly unpopular to imagine economic difficulties for Japan in 1989 and for the United States in 2006, which eerily similar to the economic opinions of China today. The fact of the matter is that every bubble in world history has never ended well. Look no further than the fallout that occurred in Japan and that we are currently witnessing in the US. Unfortunately, a real-estate collapse has an impact on the lives of a majority of the population. There are a number of examples in China of smaller cities, hundreds of miles inland from Beijing and Shanghai, where frenzied crowds pack sales events with bags of cash, buying units that only exist on blueprints. A scary thought when one realizes that average home values in these industrial outposts soared 50% last year. Hefei is one of these cities where many residents are barely a generation removed from working in the fields, the average annual income is $2000, the local economy centers on home appliance manufacturing and there are few tourists.

Interestingly, China’s equity market has a history of being one of the first emerging markets to move lower and it tends to act as a good bellwether for the future health of the global economy. In early April, we sent a notice to clients that we had turned cautious on stocks and recommended reducing exposure to equities. Among other factors, we noticed that the Shanghai index was weakening, while North American equity markets continued to surge ahead. By early May, North American markets began what would prove to be one of the sharpest pullbacks in more than a year. Although, recent economic data suggests that North American economies are still strong, equity markets are a reflection of future earnings and growth. Whether this was merely a healthy correction in a bull market or the beginning of another down leg, the market was sending strong signals back in April that caution is warranted.

In a command-driven economy with a nondemocratic political system, a severe economic pullback could be even more severe, since people will have no one to blame but the government itself. During the past few millennia, economic problems were often the precursor to the fall of the emperor–sometimes in violent fashion. Expectations for economic growth in China are debated on a regular basis. This is an economy that has grown at a feverish pace for more than a decade. As a result, continued increases in Chinese demand for commodities is taken for granted by most economists. One almost never hears about the possibility of an economic contraction, which could quite possibly be induced by a collapse of the real-estate bubble. This could be exacerbated by moderate declines for real estate prices in the rest of the world if demand begins to wane. Since China relies so heavily on exports as a major component of its economic engine, a decline in real estate in other countries will cause reduced demand for goods of all kinds just as China will be suffering the inevitable consequences of a major pullback in its own real estate. Should this occur the economic impact is deflationary, which would put downward pressure on all asset prices. On a positive note China has massive foreign reserves, including their holdings of nearly 900 billion dollars in US Treasuries, which would probably help to ease the pain in the event of a real-estate collapse.

In order to invest prudently, one always needs to be aware of the potential economic pitfalls and fallout. Whether the European sovereign debt problems persist or the real estate bubble in China begins to unwind later in the year, we believe the equity markets are beginning to look past the current strength in the economy are pricing in the possibility of slower growth ahead.

Over the past 18 months, Tactical Investing has helped us to navigate through some of the most challenging markets in history. We will continue deploying these tools and strategies in order to take advantage of suitable opportunities for clients. While a great number of investors are looking into the rear-view mirror and expecting eternal sunshine, we will keep you focused firmly on the front windshield for signs that the cyclical bull market which started in March 2009 is ending.


  • The saga at Bear Mountain appears to be heading for an unfortunate finale. The chief restructuring officer overseeing the Bear Mountain Master Partnership has been granted the right to assign the companies within the development into bankruptcy. A Supreme Court ruling last week has given Robert Holmes of Prowis, the go-ahead to bankrupt the companies in an effort to recoup a portion of the monies owed to unsecured creditors. The project owed secured creditors in excess of $300 million on March 25th when the development was placed under creditor protection at the request of its largest lender – HSBC Bank Canada, and CEO and co-founder Len Barrie was removed from his role. How much is owed to unsecured creditors has yet to be determined and the development continues to operate with funding from HSBC.
  • Real estate titan Nat Bosa has made Capilano University’s Christmas card list going forward. Nat and his wife Flora have donated $6 million to the University, making it the largest donation in the school’s history. Bosa has significant interests in the film industry, owning Mammoth Studios and North Shore Studios with his sons, and has designated the bursary to Capilano’s new Centre for Film and Animation. The new centre will focus on 3-D and high-definition filmmaking, complimenting the existing film and animation school.
  • While British Petroleum (BP) claims that its plan is “going according to schedule,” the public is growing increasingly frustrated with the lack of progress that now sees the disaster in its 6th week. BP isn’t the only one facing criticism, with much of the recent attention being focused on President Obama who is defending accusations that he and his administration have been too slow to react. The spill has now eclipsed the Exxon Valdez spill in Alaska to become the worst oil spill in US history and has lead to rapid changes to offshore permitting. Obama has implemented a 6-month moratorium on drilling offshore and suspended 33 deepwater operations already at work in the Gulf of Mexico. BP’s latest effort has also failed, announcing Sunday it has abandoned its “top-kill” procedure that used a heavy mud mixture to attempt to plug the exit. A new tactic is being assembled now and should be ready to go mid-week but the challenge is clearly baffling all the experts and the company admits this could go on well into the summer months. Millions of litres have poured into the Gulf since April 20th and Louisiana’s eco-sensitive coastline is in jeopardy as a result.

Marketwatch – A Look at the Week’s Newsmakers
Research In Motion Ltd (RIM) – the Blackberry Partners Fund is setting up operations in China through a $100 million USD partnership with China Broadband Capital Partners. The Fund, which now sits at $150 million, is a joint venture of Research In Motion Ltd, Thomson Reuters, RBC Venture Partners, and JLA Ventures. The China-focused affiliate fund will solely concentrate on the promotion of mobile application development in the world’s largest cell-phone market. The consortium hopes this is the first of many global ventures designed to take advantage of strategic products that will be unique to certain regions. In a recent statement, RIM co-CEO Jim Balsillie said the new Blackberry Partners Fund China would help fuel substantial innovation in the mobile ecosystem, in China.  
Cliffs Natural Resources Inc (CLF) – the Cleveland, Ohio-based miner continues to make in-roads into Canada through the acquisition of small companies in strategic geographic locations. After entering into a joint-venture with Vancouver’s First Point Minerals Corp in November, Cliffs announced two new targets last week with the news it has unveiled hostile takeover bids for KWG Resources Inc and Spider Resources Inc, both located in Northern Ontario’s Ring of Fire. Cliffs is focused on becoming a dominant player in the region’s Big Daddy chromite project, which would be a first in North America. The area is very remote and will require a major with deep pockets to take the project to the next phase.
Agrium Inc (AGU) – CEO Mike Wilson is aggressively pursuing the company’s next acquisition after its failed bid to land CF Industries Holdings Inc. In an interview at Bloomberg headquarters in New York City, Wilson reiterated Agrium’s focus on building out its North and South American operations. “We don’t wait for someone to knock on the door,” he said. “You’re going to see organic growth and acquisitions.” Wilson has always been aggressive, completing nine acquisitions over the past five years and appears ready to maintain his approach.

“Quote of the Day

“The major difference between a thing that might go wrong and a thing that cannot possibly go wrong is that when a thing that cannot possibly go wrong goes wrong it usually turns out to be impossible to get at or repair.” – Douglas Adams (1952 – 2001), Mostly Harmless

JAMIE SWITZER | Raymond James Ltd.
Senior Vice President, Financial Advisor
North Vancouver IAS
PH: 604.981.3355 | FAX: 604.981.3376

MARC LATTA | Raymond James Ltd.
Senior Vice President, Financial Advisor
PH:604-981-3366 | FAX: 604.981.3376

Suite 480, 171 West Esplanade
North Vancouver, British Columbia

This newsletter expresses the opinions of the writers, Marc Latta and Jamie Switzer, and not necessarily those of Raymond James Ltd. (RJL)  Statistics and factual data and other information are from sources believed to be reliable but their accuracy cannot be guaranteed. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities.  It is not meant to provide legal, taxation, or account advice; as each situation is different, please seek advice based on your specific circumstance. RJL and its officers, directors, employees and their families may from time to time invest in the securities discussed in this newsletter. It is intended for distribution only in those jurisdictions where RJL is registered as a dealer in securities. Any distribution or dissemination of this newsletter in any other jurisdiction is strictly prohibited. This newsletter is not intended for nor should it be distributed to any person residing in the USA. Within the last 12 months, Raymond James Ltd. has undertaken an underwriting liability or has provided advice for a fee with respect to the securities of the Royal Bank of Canada. Raymond James Ltd is a member of the Canadian Investor Protection Fund.