News Analysis date published New: 
Tuesday, August 28, 2012 - 13:30
New Date created: 
Tuesday, August 28, 2012 - 16:56
New Date last updated: 
Tuesday, August 28, 2012 - 13:30

This Stock Could Tumble, Thanks to China's Lies

Tuesday, August 28, 2012 - 1:30pm

Living halfway around the world, it's hard for most of us to really know what's happening in China. But more and more, what happens in that country affects the global economy and stock markets -- and eventually your portfolio.

We do know the Chinese economy has been through a stunning multi-decade boom, which has catapulted it past countries such as Japan and Germany. We also know one other salient fact: Chinese political leadership continues to stick with a "command and control" policy, which has, at least until now, been more effective than many would have suspected. Yet increasingly, that heavy-handed top-down control is showing signs of deepening trouble -- if media reports are to be believed.

Cracks emerging?
Some well-known investors, most notably short seller Jim Chanos, have been insisting for quite some time that the Chinese economy is in trouble. Yet the monthly data provided by the government point to continued growth and only hint at small signs of slowing growth. Then again, Chinese government statistics are more propaganda than fact.

However, in recent weeks and months, the global financial press, which has a direct presence in China, has been making a repeated case that China is in far more trouble than many suspect. The Economist, for example, has written about how an untold number of newly-built apartment buildings are sitting vacant -- with zero interest from consumers. [Watch this Australian newsmagazine's report on China's "ghost cities" -- you'll be shocked if you haven't seen this before.] More recently, The New York Times published this article, which explains how the country keeps producing goods even in the absence of demand.

If this report is correct, then it shouldn't come as a surprise. The Soviet Union showed us decades ago that the entire premise of a "command and control" economy has one central flaw: Government can dictate what companies should be producing, but it can't force consumers to buy them. And without the natural push and pull mechanisms built into supply chains, manufacturers have no way of quickly responding to changes in demand.

Paralysis -- at precisely the wrong time
China is gearing up for its once-every-five-years rotation of political leadership. According to various media reports, there is a pitched battle between the old guard (which wants to continue the current command and control policies), and the new guard (which argues for a more traditional capitalist approach). It's not clear which side will come to dominate the next era in the politburo, but it is clear that the government is ill-inclined to make any moves while the politics heat up.

Sure, China is adding stimulus to certain areas of the economy, but any moves to boost production would be coming right at a time when unsold goods are already in abundance. "Let's make more" hardly seems the wise policy move. China, in its efforts to steer a soft landing, may be unwittingly steering a course for a hard landing as it pulls the wrong economic levers.

Adjusting exposure
There is no other stock in my $100,000 Real-Money Portfolio that is as vulnerable to China than copper and gold miner Freeport-McMoran (NYSE: FCX). When I recommended this stock four months ago, I noted that global copper demand appears set to exceed supply by 2013, even in a period very weak global economic growth. According to various forecasts, that still appears to be the case.

Trouble is, we simply have no idea what is happening in China. We don't know how much the economy is slowing, and more to the point, we don't know the size of China's copper stockpiles. And if China stumbles, then what does that mean for copper prices? Well, they can surely go lower, as this five-year chart shows.

My head tells me that copper producers are poised to benefit from constrained long-term supply. My heart tells me that China is becoming a wildcard that few still seem to recognize. In such a state, I'm going with my heart.

I recommended this stock at $37 and it is now $36. I simply want to avoid the prospect of larger losses. The fact that this stock was below $32 in late July tells me where this stock might return in coming weeks. Why that number? Because that's where this stock stood before investors developed a sense that the Federal Reserve would provide another round of stimulus to the economy -- which is always good for commodity stocks in the short-term.

How much of the recent gain already reflects the Bernanke boost? It's hard to say, but it's worth noting that the Fed chairman is set to speak on Friday, Aug. 31, in Jackson Hole, Wyo., and any signs that he won't take action at the next Fed meeting could cause commodity stocks to reverse course.

Risks to Consider: As an upside risk, if the Chinese economy doesn't slow as much as I fear and if Bernanke indeed gives the economy another round of juice, then this stock could easily move into the $40s. But that feels more like gambling than investing.

Action to Take --> As such, I will sell my 200-share stake in Freeport-McMoran 48 hours after you read this.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of FCX in one or more of its “real money” portfolios.

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