Unexpectedly Intriguing!
17 August 2009

Barry Ritholtz looks at China's stock market and comments: "Today we will get a real test for whether the recent pullback is merely a buying opportunity, or the start of something more serious."

The answer to both questions inherent in Barry's comment is: yes.

A Buying Opportunity?

Where the U.S. stock market is concerned, the answer to this question in the very short term is yes. As we've demonstrated the role of dividend futures in determining the level of stock prices throughout much of this year, we find today that the level of expected future dividend payments ended last week by ticking upward, which contradicts today's drop in stock prices.

What that tells us is that the stock market's drop today is the result of noise. Without a corresponding drop in the expected level for future dividend payments, we would anticipate that today's drop in stock prices will be short lived, which would make today a short-term buying opportunity. But before you consider running out and buying U.S. stocks today, understand that we *really* mean short term, as measured in days, possibly in weeks, but not much more than that at this time, for reasons we've already stated....

Something More Serious?

The question, whenever we see this kind of noisy action in the market, is "what's behind it?" In this case, we believe the source of noise is emanating from China's stock markets.

Previously, we had found that there was no bubble in China's Shanghai stock exchange, as the growth rate of its stock prices have largely paralleled those of the U.S., where we've demonstrated the rise in stock prices since 9 March 2009 has been driven by the expectation that the economy is becoming "less bad." We believe the same outlook applies to investors in the Shanghai market.

So, without a bubble where stock prices have become decoupled from their fundamental drivers, the primary factor affecting stock prices are changes in what investors expect for the future level of dividend payments.

Here, looking at China's stock prices, we find that the Shanghai Composite index has recently dropped quite a bit in recent trading. Unfortunately, we don't have any information on that market's dividend futures (or dividends per share for the index itself) and we have not found any specific news related to companies that are listed on the exchanges as having cut their dividends in the past week, so we can't directly tell if a change in that aspect of the Chinese market is driving the drop in stock prices there. So, once again, we have to do our analysis of China's stock markets by proxy.

We can't use Greater China Holdings (GCH) this time, as the U.S.-based stock had slashed its dividend payout to zero last year. So, scanning the world of companies that have strong links to businesses in China, we found news that Manulife, a Canadian insurer that has the most exposure of all international insurers to China, had cut its dividend by 50% on 6 August 2009.

Barry Critchley of the Financial Post reports:

Manulife justified the dividend cut as part of its plan to "remain focused on achieving fortress levels of capital in all of our operating businesses, as well as at the consolidated Company." The cut will save about $800-million.

That plan sounds very familiar to observers of the U.S. banking and financial companies that have been the most exposed to fallout from the aftermath of the U.S. housing bubble.

We believe the fall in stock prices in Shanghai first, and now in U.S. stock markets, is directly tied to speculation that Manulife is attempting to protect itself from its large exposure to the health of the Chinese economy. With that economy believed by many observers to be artificially inflated as the result of immense levels of stimulus spending by the Chinese government, Manulife's action to halve its dividend would be an indication that the company is looking to build up its capital in anticipation of a declining economic situation in China.

That, if it comes to pass, would be a very serious thing indeed. At present, without a clear signal that cuts in dividends in China's stock market are in the works, speculative noise may be assumed to be behind the drop in stock prices, both here and in Shanghai.

And thanks to the noise that the U.S. stock market would appear to be importing from China, we have both a buying opportunity and the start of something potentially more serious. Welcome back to your nervous nirvana!

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