Avoiding China, Russell 2000, and REIT's

Michael Santoli's editorial column this weekend (within Barron's) was right on target in my opinion, as China has now become to the decade of the 2000's, what Japan was to the 1980's, i.e. the hot market, the economic model to be worshipped and the "it" economy, kind of the Paris Hilton of global economies, and you really can understand why when the latest "reported" GDP growth for q1 '07 for China was north of 10%.

Michael Santoli talked about the P/E multiple of the Shanghai Stock Exchange being "50(x) earnings" which one could deem as an expensive valuation, but my thought when I read that was "what constitutes earnings" ? Throughout my career when I've heard analysts or portfolio managers or whoever talk about the valuation of a foreign stock or foreign market, you don't often hear them talk about the quality of those earnings.

Because of the global economy, the world seems to be moving towards a uniform set of accounting standards, which would leave companies from different countries with a more uniform set of financial statements for analysis. In fact if we dissected China's corporate earnings, we could find the Shanghai trading at 100(x) earnings or 20(x). (I'll let you guess which valuation is more likely.) Most people, if you listen solely to the news, probbaly have forgotten that China is still a Communist country, and although unlikely, could still wake up one day and see that the government has "appropriated or nationalized" the country's asset base. (The risk is small, but it is there, or maybe some derivation thereof...)

For present clients, we are staying away from international in general, and China in particular for the time being, given the enormous popularity of investing "internationally" and given that if China should crack, there is a high likelihood of a contagion effect throughout Southeast Asia. According to one source, over 90% of all mutual fund inflows in 2006 (can't remember if it was an Investor's Business Daily article, or an IBD article referencing a Citigroup research piece where we read the statistic) went into "international" funds, and we'd love to own this asset class, just not now.

Regarding the Russell 2000, small-caps have outperformed large-caps, particularly the S&P 500 for 6 - 7 years running, and the valuation of the Russell 2000 is almost twice that of the S&P 500, interms of the P/E ratio.

Tony Dwyer, the equity strategist at FTN Midwest and a frequent CNBC contributor, e-mailed me some data on Friday showing that the Russell 2000's P/E is 28(x) trailing earnings for 15% y/y growth, or almost 2(x) PEG. In and of themseleves these statistics aren't bad, but when compared to the S&P 500's 16(x) forward eps for what has been quarterly growth of 10% - 15% year-over-year year earnings since the March, 2003 bottom, you can quickly see that the S&P 500 is more attractively valued than the R2K, and the S&P 100 (or the top 100 stocks in the S&P 500) is even cheaper than the entire index. (In April, '07, the S&P 500 rose 4.43% while the Russell 2000 increased just +1.80%; I don't know or want to say that that is a trend, just the amount of underpeformance was surprising. You would think - at some point - that large-caps would "mean-revert" and start to outperform small-caps.)

Finally, although we have recently bought the XHB (homebuilder's ETF) for some client accounts, we are staying away from REIT's in their entirety, although commercial property REIT's still seem to have a decent valuation given the strength of corporate cash flow.

We'd love to own all these groups once again, particularly international via Oak Mark's David Herro's International Fund, David being one of the best portfolio managers in the international asset class today, but I would prefer to wait until we get an inevitable currency disruption or exogenous event to take hot money out of these groups.

To conclude, we sold our Russell 2000 too early in 2004, 2005, and we sold our REIT's too early as well, and we continue to think that the S&P 500 remains relatively cheap, and unloved relative to the rest of the world.

long S&P 500 index funds, SPY