Yardeni On China's Stock Bubble Bursting & Rethinking US Stocks

July 13, 2015

Ed Yardeni is president and founder of Yardeni Research, a global investment research strategy firm. A former economist for the Federal Reserve Bank of New York, he is widely followed by institutional investors for his investment strategy publications. Dr. Yardeni is often seen on CNBC and is published in financial publications like the Wall Street Journal, The New York Times and Barron's.

ETF.com: What's happening with China's stock market? Of course, we've seen a pretty long rally, so a correction isn't completely out of the ordinary. But it does seem like something is out of the ordinary here.
Ed Yardeni: China seems to have inflated a stock market bubble in record time. The People's Bank of China started to lower interest rates again in November and that seemed to have fired up the speculative mood in China. Many Chinese have a very high savings rate. And so they need to put it somewhere.

For the past several years, Chinese investors have been putting their money into property, into real estate, buying second, third apartments that have been sitting vacant in these so-called ghost cities. But the government tried to discourage that kind of speculation, and raised the down-payment requirements. And so Chinese investors, with all this cash around, have been pouring into the stock market.

They created a huge bubble in record time that's bursting. I don't think this is a correction; I think this is a bursting of a speculative bubble. And the fact that the government is resorting to all these desperate measures—suspending trading and prohibiting selling—just worsens the prospects for the stock market. Who's going to want to buy into a market where the government can mandate that you can't sell your position?

This is going beyond the stock market and creating a real credibility problem for the government. For many years, everyone's had confidence that the government could manage the economy and could provide the kind of programs necessary to keep the economy growing. But they're really blowing their credibility big time here with this effort to prop up the stock market in an economy that's clearly slowing and has lots of problems, particularly excess capacity, deflation and too much pollution and corruption.

ETF.com: Is this something that could reverberate to American investor?
Yardeni: The most immediate investment implication is that China's growth will continue to weaken, which is already putting more downward pressure on commodity prices. I would certainly not want to be long any commodity-related securities, whether it be gold, gold miners or copper shares.

It's been interesting to note that gold hasn't rallied on all the commotion in Europe and in China. And that's because gold tends to follow the trend of industrial commodity prices, and they're falling.

On the other hand, the U.S. economy is looking more and more resilient. It's likely to weather the overseas storm in Europe and in Asia. We have a very resilient, diversified economy. The U.S. consumer is in relatively good shape. Housing activity is picking up. It may very well be time to switch back from the "Go Global" investment strategy with a capital G on both of them, to a "Stay Home" investment strategy, with a capital S, capital H.

Throughout this bull market, I've been promoting a "Stay Home" investment strategy, but I wavered in the beginning of the year, conceding that we couldn have some outperformance overseas, because the U.S. is relatively overvalued relative to Europe and some other markets. But I think the fundamentals now point back to the U.S.

And all this commotion increases the odds of only one rate hike over the remainder of the year, one-and-done. But none-and-done also looks increasingly likely.

ETF.com: And do you think a rate hike is built into that yet?
Yardeni: I think so, especially if the perception is it'll be one-and-done. The Fed will raise rates not because it really wants to raise rates, but it just wants to demonstrate it can do it. It needs to do it for its credibility's sake. And then it'll just hold off for another six to 12 months before it does anything again.

ETF.com: What do you think is going to happen with the dollar when rates rise?
Yardeni: The dollar could very well continue to rise. And that's a negative for the market because earnings get hit when the dollar rises. But the big negative, really, for earnings has been the plunge in oil prices. It's reduced the earnings of the S&P 500 energy companies by about 50 percent. The other companies benefit from lower energy prices. So, to the extent to which they were hurt by a stronger dollar has been partly offset by lower energy costs.

On balance, the earnings outlook is still pretty good in the U.S., excluding energy. Even in the first quarter, earnings were up 11 percent, excluding energy, but up only 1.5 percent with energy. I think it's going to be a strong earnings year, excluding energy. And we'll have another good year next year. And that's what should allow the market to move higher.

The leadership's going to be in the areas where we're seeing the most merger-and-acquisitions activity. If interest rates are going to stay low and global growth prospects are going to slow, the incentives for M&As will continue to be very strong.

ETF.com: Why don't you think we've seen any M&As in the energy space?
Yardeni: Because of the uncertainty of where the price was going to settle. Once there's a little bit more certainty that it's either $40, $50, $60 or $70 a barrel, you'll start to see some significant M&A. But until we get some stability in the price of oil, M&A in energy is going to stay fairly light.

Meanwhile, health care, technology will continue to see M&As, but financials are highly regulated, so I don't think there's going to be much there. Industrials have already consolidated.

ETF.com: What are some of your concerns that you think investors should be looking at?
Yardeni: All the major risks to the market are in the headlines. The question is, do they get much worse? How does the Greek drama play out? If it ends with the Grexit, what kind of issues will that create in Spain and Italy with the socialist parties that say "we want out, too"?

I don't see these issues becoming contagions, but that is something to watch out for. Somehow or other, the meltdown in China's stock market, the turmoil over Greece could become a global contagion and depress global economic growth to such an extent that it affects the U.S. But I don't see that at this point.

We don't really have to be too original here and come up with new things to worry about. There are lots of issues making the headlines that are going to be with us probably through the end of the year.

PowerShares S&P SmallCap Health Care ETF (PSCH | A-37)

Dr. Yardeni believes the American economy is "looking more and more resilient." In his worldview, the whole U.S. stock market is going higher, but leadership will come from areas with strong M&A activity such as health care and technology. Health care seems particularly attractive in light of the fact that it's domestically focused and not affected by a rising dollar—which Dr. Yardeni thinks is a strong possibility. Within the health care sector, small-cap companies are most likely to benefit from the ongoing M&A activity. PSCH puts all these themes together in an efficient and relatively inexpensive package. The fund's portfolio is composed of U.S. health care companies with an average market cap of under $2 billion. Its small-cap nature tilts it heavily away from pharmaceuticals and toward health care services and supplies—a feature that could further shield it from overseas troubles and a rising dollar. PSCH has adequate liquidity, but trades should be executed with limited orders near iNav, as its premiums/discounts can be volatile. The fund is currently on our "Opportunities List."

IQ Merger Arbitrage ETF (MNA | D-92)
According to Dr. Yardeni, slow global growth and extremely low interest rates create powerful incentives for the M&A frenzy to continue. Funds based on a merger arbitrage strategy are likely to do well during this trend. MNA is the biggest and most established ETF in the space. The fund aims for absolute returns (uncorrelated to the market) by taking long positions in stocks that are reported targets and offsetting them with short positions in broad equity indexes. MNA's straightforward approach has delivered stellar performance since its inception more than five years ago. The fund has sufficient liquidity to execute trades without incurring prohibitive costs if handled carefully.

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