by Kevin Klombies, Senior Analyst,

SHAOXING, China — Government statistics show that 67,000 factories were shuttered in China in the first half of the year, said Cao Jianhai, an industrial economics researcher at the Chinese Academy of Social Sciences. By year’s end, he said, more than 100,000 plants will have closed.

We tend to believe that the markets work more in cycles than secular trends. Capital moves from sector to sector and theme to theme chasing higher returns and momentum and along the way- if enough analysts, strategists, economists, and so-called experts say it enough times on television or in print- people begin to believe that this time is different, that it is safe to invest in the ‘hot theme’ because, after all, people have to talk, people have to eat, people have to drive, etc. Then, as usual, the boom turns to bust.

China reminds of us the tech/telecom/internet sectors in 2001. In fact… we have done numerous comparisons over the past year or so arguing that the rise in China’s equity markets was a replay of the Nasdaq into 2000. With the benefit of a few quarters of hindsight we return to the argument.

In the simplest terms possible the 1999- 2000 internet bubble represented the tail end of a longer-term tech trend just as China’s stock market rose towards the end of an extended commodity bull. Our point, however, is that some 8 years after the Nasdaq’s peak all or at least most of the wonders promised back in 1999 have arrived. We have high-speed, wireless, e-commerce, search, and multiple-computer families. You can book a trip online, play computer games on line, buy and sell goods and services online, do research online, email, instant message, chat, text, video conference, gamble, trade… and yet…. the Nasdaq closed yesterday at one-third the levels seen at the peak more than 8 years ago.

The point? When the Nasdaq went from boom to bust in 2000 it drove interest rates lower which marked the end of one trend and the start of another. We have argued in the past that the collapse in U.S. capital spending post-2000 led into a consumer spending-driven cycle that created, in turn, a massive capital spending cycle in Asia (as commodities were consumed to build factories to make goods to ship to North America). The leading edge of the U.S. consumer spending cycle showed up through strength in the home builders’ stocks (we use Hovnanian (HOV) relative to the S&P 500 Index (SPX) at top right). The offset to weakness in U.S consumer spending in 2007 has been a decline in the demand for raw materials to build new factories even as tens of thousands of factories already built are shuttered.



Equity/Bond Markets

To quickly finish off today’s first page argument… while there will always be some amount of consumer spending in the U.S. our view is that the next cycle will be driven by capital spending. On the other hand the next Asian growth cycle will be powered by local consumer spending which is why we are still leaning towards large cap consumer-oriented stocks that many believe have limited growth prospects. Earnings growth for Coca Cola, McDonalds, Johnson and Johnson, and even General Motors will be driven by Asian instead of North American demand.

In any event… it is time to move on. Below we show a long-term chart of the ratio between Exxon Mobil (XOM) and Boston Scientific (BSX). The chart represents one of our efforts to capture the way the markets shift from the energy/commodity theme to the defensive/health care theme and back again.

The XOM/BSX ratio peaked in late 1993 and then rose to a top roughly seven years later in 2000. It made a third peak seven years later around the end of 2007. Obviously it has recently spiked to new highs but we still view that as more of a market-driven mystery than an extension of the trend.

So… what happened in 1993 and 2000? Our view is that the best answer comes from the chart at top right. This chart compares the ratio between steel maker Nucor (NUE) and Boston Scientific (BSX) with the ratio between Hong Kong’s Hang Seng Index and the S&P 500 Index (SPX).

The idea is that the change from energy/commodity back to health care occurred at those times when Asian cyclical growth had reached a peak. In other words 2008 is similar to 1993 in particular because this was the year when the Hang Seng peaked relative to the SPX concurrent with a major peak in the share prices of the steel makers.

We have also argued from time to time that the share price rise for WMT since the second half of 2007 has been an offset of sorts to weakening economic growth in Asia. In other words as the Hang Seng Index/S&P 500 Index ratio has declined… WMT has risen. On page 1 we suggested that the home builders started to show relative strength following the Nasdaq’s peak in 2000 in anticipation of a robust consumer spending- driven cycle anchored in rising home prices. One of the likely offsets to weaker Asian growth this year has been the U.S. large cap consumer sector.