Not since the Great Depression have we seen such horrendous volatility and uncertainty shaking stock markets and financial institutions worldwide. It’s not over yet, but we see important global changes emerging from the current meltdown.

In the search for the causes of the current crisis, the financial world is only getting started. Historians will argue for decades about the triggers and the systemic flaws that brought us to the edge of a financial abyss.

Every passing month brings new flaws in the system to light. Subprime mortgages were the primary target. Then the collapse in housing sales and prices followed. Widespread defaults led to a credit crunch. And this chain of events revealed what Warren Buffett once called financial weapons of mass destruction, credit default swaps. These poorly understood and unregulated instruments, have been directly blamed for the destruction of the world’s largest insurer, AIG, and the loss of confidence America’s proudest financial institutions.

As investors in Chinese stocks we have two important lessons to learn from this historic shakeup. First of all, none of the problems that have brought U.S. financial giants and the U.S. economy to the brink of disaster apply to the Chinese economy. None.

Secondly, we have been forced to accept the fact that solid fundamentals among Chinese investments are not a bullet-proof shield. Unfortunately, many Chinese companies experiencing double-digit profit increases have been dragged into the mud by America’s financial panic.

Why have Chinese companies been dragged down by events that are occurring a world away? There are a number of reasons. Even top-flight U.S. companies like General Electric have been hammered to unthinkable prices over the past month because a number of major hedge funds are being forced to wind up their operations and sell enormous blocks of stock at any price they can realize.

Jim Trippon Speaking at the Hong Kong Stock Exchange
during the 2008 China Investors Field Trip, October 2008.

The Financial Times of London predicts that one third of the world’s hedge funds will soon cease to exist. Keep in mind that thousands of these funds worldwide invested in stocks and derivatives with borrowed money and with money that panicky investors are now demanding back. The Financial Times says, “Hedge funds have played a leading role in the evolution of the credit crisis, which can be traced back to the difficulties experienced by hedge funds that were sponsored by Bear Stearns, the US investment bank, early in summer 2007.”

Because these funds are unregulated, it is impossible to know exactly what their holdings are, but we can see the effect of massive redemptions in the wild fluctuations that occur in the course of a single day on major indexes. As large blocks of stock are liquidated, prices begin to fall sharply, only to swing in the other direction briefly before the selling binge resumes.

There can be little doubt that Chinese stocks have been among the holdings of thousands of hedge funds who sought to diversify risk around the world. Because these stocks are unknown to most retail investors, they have not rebounded as strongly as better-known companies the after major funds redeem their positions for whatever price they can realize. This creates tremendous opportunities for us. For example our top China pick from two weeks ago is already up a staggering 58%. Stay tuned for even greater opportunities ahead.

Committed to Your PROFITS from China,
Jim Trippon, Editor
China Stock Digest