China Stocks Roaring Ahead of the Rest of the World.
More to Come?

The Shanghai Composite Index (SCI) continues to roar ahead of other global indexes again with gains this year of more than 35%! The news is even stronger if we look back to the very beginning of the market's recovery in China last year.

At its worst low, the SCI followed the rest of the world's markets to the basement in 2008 with a nosedive below the 1500 mark. But this week the Shanghai Composite Index burst above the 2500 level (while most of the world's major markets remained mired in the red). Unfortunately, investment on the Shanghai Exchange is off limits to most foreigners but that doesn't mean big stock moves inside China aren't important.

Our first message to investors is a warning. For the time being stay away from Exchange Traded Funds that claim to mimic China's economic growth. They do not.

The most popular China ETF, the iShares FTSE/Xinhua China 25 Index (FXI) has lagged Shanghai's performance with a gain of only 10% year-to-date. The competing iShares MSCI Hong Kong Index Fund has done only a little better with an eleven percent gain. The PowerShares Golden Dragon Halter USX China Index (PGJ) rounds out the index of underperformers with all showing losses in the forty percent range from their peaks last year.

Why have they underperformed? As we mentioned in an earlier bulletin, indexe funds that focus exclusively on China tend to invest in the largest cap companies, and that usually means they are usually State Owned Enterprises (SOEs). These SOEs are often much more loyal to Beijing than they are to retail investors. That means that a company like China Life (LFC) will do as it's told if it is instructed by Beijing to invest heavily in a falling market in an effort to prop up that market. LFC lost heavily on such market manipulation plays last year.

Companies like China Petroleum & Chemical Corp. (SNP), one of the world's largest refiners, must simply absorb losses if the government clamps on price controls. That's why we often prefer more independent companies.

The China Stock Digest is currently cherry-picking stocks and we continue to do so in a very conservative fashion. The Shanghai Index has hit its 250 day moving average and isn't expected to rise a great deal further in the very near term. Meanwhile ADRs of China-based stocks continue to feel the negative effects of Wall Street volatility.

We are looking for much more of a decoupling from western markets. On one hand we have China-based stock markets (and the entire Chinese economy) moving strongly into recovery mode. The Chinese Premier reinforced that impression with a strongly optimistic statement over the weekend. On the other hand we have "developed" economies still mired in recession, with marginal recovery not expected before the end of this year at the earliest.

The triggers that could drive the Shanghai Index even higher and boost the Chinese economy even further may be on the horizon. Industrial production in China has ballooned by 8.3 percent in March, more than double the previous two months. Exports are also showing signs of a greater upward trend.

But the big news we are waiting for is a second stimulus plan from Beijing. There are rumors swirling among credible sources in China that the government will unveil a second stimulus plan and this one could be more important than the $586 billion cash injection announced last November.

The best possible news from China would be a stimulus plan directed at consumers. All sources agree that China must consume more of what it produces because world markets are continuing to cut back on Chinese imports.

But China has had great success with pilot incentive programs to encourage appliance and auto purchases in relatively poor regions.

We believe that a national plan to boost consumer spending and reduce China's habitual saving tendencies is in the works. It could be announced before the end of the week. If that happens, watch out for even more gains among stocks traded in Shanghai and a decoupling of Chinese ADR prices in New York from the valuations of faltering U.S. firms.

China can never again separate itself from world markets entirely. But it is looking more and more as if China's powerful internal economic momentum combined with very rapid and focused stimulus measures will spread the optimism of the Shanghai Stock Exchange to shares traded around the world.

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