Shanghai Stocks -- Living Down The Past

My view for this year is that the Shanghai would rally over Half 2 '11 and sustain an advance well
into next year.The problem this year has been money and credit tightening to cool a very sharp
acceleration of inflation. Business profits have advanced, but the p/e ratio has declined sharply
as higher inflation forces up return hurdle rates.

The central bank (PBOC) has been running a tighter money policy for nearly 18 months, with China
M-2 now down to +12.5% yr/yr. Assuming level money velocity, we should expect 9.5% real GDP
growth with a 3.0% inflation rate. But strong credit growth has pushed up velocity, and pressure to
curtail the overheat has resulted in +9.1% real GDP yr/yr  but inflation of 6.0%. Now although it
could be that inflation has just crested, the downward trajectory of the growth of money and credit
could carry real GDP growth lower too, even as inflation pressures subside.

Compared to the past 5-6 years, M-2 money growth is the lowest it has been which may add
downside risk to the real economy and profits. China has also allowed large 10-12% wage gains
this year. This firmly increases consumer purchasing power, but the wage hikes could constrain
profit margins ahead and slow down the inflation deceleration process.

Since the current downward trajectory of money and credit gowth if extended well into 2012
could damage China's economy and its real estate development markets in particular, It makes
sense to conclude the PBOC is probably closing in on starting to ease monetary policy. This has
been a troubling period for the PBOC, because unofficial or black market lending has turned
out to be larger and more vigorous than they thought (So they say). China businessmen, rather
than leave money in the bank at low deposit rates can, if they are careful, lend out excess cash on
the black or "stir fry" market at far higher rates. The tougher lenders can dishonor the families
of slow payers and use muscle as necessary to collect. At the same time, smaller businesses
are driven toward this market as more rationing of credit by the big banks freezes them out.
The PBOC would be wise not to sit on the brakes for too long, as bringing small business
borrowers back into the official fold would be more advantageous economically.

The Shanghai market closed 10/20 at critical support of 2331. It is an oversold market, but a
sustainable advance may await signals and confirmation that the central bank is prepared to
abandon monetary tightening.

I have been surprised by the weakness of the Shanghai this year, and my projection of a positive
second half turn is running out of time. Shanghai ($SSEC)