Clouds Gather as China Bulls Celebrate

NEW YORK ( TheStreet) -- Although I have been bearish on China for 18 months or so, late last year our work showed there would be a bear market rally in the China economy and stock market. That happened right on schedule.

The latest GDP growth number increased to 7.9% from 7.4% the prior quarter. We don't believe China's governmentally produced economic numbers any more than we trust those from Washington. Our expectation was based on the national congress and appointment of a new China leadership.

Engineering a period of optimism makes it easier for a new government. And under communism, what the government wants is what the government gets, even if it is a Potemkin village.

However, foreign direct investment flows in December continued the one-year declining trend, down a hefty 4.5% for the month. That means foreign capital is flowing out. In emerging markets, that's usually a very big warning signal. It's much more important than the GDP number.

Late last year, China relaxed rules on foreign investments in Chinese stock exchanges. To us, this was a confirmation of the urge to raise foreign exchange and reverse the outflows.

China needs foreign exchange to pay for its global shopping spree. They are buying up natural resources around the globe at an accelerating pace. The big deals get publicity. But there are many smaller deals you never hear about. China knows that the only real assets are what is in the ground, not what the central banks create with their computers.

They also need foreign exchange to support the huge gold purchase program. Currently China is the second-largest gold producer. We suspect that China also wants to be the largest gold owner in the world.

China's big problem is that it is so dependent on exports. It's about 70% of the economy. And it can't do much about the decline in export growth. To see what's happening to exports, let's look at shipping, as obviously the goods have to be shipped.

The chart of the Baltic Dry Freight index shows the shipping rates. If there were a meaningful pickup in shipments, we would expect freight rates to rise. Obviously, that's happening. Here is a chart of the Baltic Dry Freight index going back to 2002 (courtesy of www.investmentTools.com).

Note that the current freight rates are virtually at the crash lows of 2008, the depth of the global crisis. At that time, world trade came to a virtual standstill. The current lows mean either that ocean shipping firms have found the secret of transporting goods at very low cost, such as solar-energy or perpetual motion, or there is a huge oversupply of ships, or not as many goods are being shipped.

We believe the problem is the latter.

Over the long term, true economic growth will be very hard to come by in China. That's contrary to popular opinion. The huge post-2008 financial stimulus is over and created only bubbles in real estate, inflation and speculation. China won't repeat that. Entrepreneurial freedom is required at this stage of the long-term cycle. But communism and corruption stand in the way of that. Phony GDP growth numbers don't create actual growth.

Andy Xie, a great observer of the Asian economic scene, writes in a recent report:
The statistics in emerging economies are not accurate. The GDP data in China and India, for example, do not reflect their 2012 slowdown. My estimate is that the growth rate in emerging economies declined by half in 2012 from 2011. It could be seen in trade stagnation and weak commodity demand.

This concurs with our view that the emerging markets are very vulnerable right now. But that's where most analysts recommend investing.

However, governments can play their flim-flam game for a long time before the masses catch on. We are now of the view that the decision has been made at the highest levels in China to whitewash all official numbers, making everything look beautiful. The statistics will continue to be positive for awhile and the negatives will be hidden.

Don't be fooled!

Wishing you successful investing.

For free periodic reports, go to www.dohmencapital.com and just enter your email address.