Is Our Nation's Largest Creditor Telling The Truth?

Our Monthly Performance Update
China: The Economic Elephant in the Room?
Chinese Fool's Gold
Smoke and Mirrors
Superbubbling Over?
Trade Earnings of the Impossible Kind?
A Drop in the Bucket
Interesting Reading
Portfolio Performance Analysis
Why Pigeons Walk Instead of Fly in Boise Idaho

Was the flash crash a market related fluke, or could it be telling us something about our future?  When most investor's think back to the most recent bear market, many remember Bear Stearns, Lehman Brothers, and the gut grinding months of September, October, and November.  The event was so traumatic that it is easy to forget how it all got started. 

The first shot across our bow was in August of 2007.  As it turned out, most of the larger quantitative based market neutral long/short hedge funds had become correlated with their positions and didn't know it.  Each thought they had developed some super secret alpha generating model, but actually these funds had developed similar models that were making the same trades.  Everyone's super secret computer model had found the same edge in the data. 

In August of 2007, the perfect storm hit causing these funds to unwind their trades at the same time causing huge losses for their clients.  When there is no one to take the other side of your trade, it is painful.  The losses were so large that it caused many hedge funds to close their doors.  Even Goldman Sachs had to close down some of their billion dollar funds, so it must have been completely unexpected.  Genius failed again.    

What happened in August of 2007 and the flash crash in May of 2010 seems eerily similar.  Do you recall what happened next?

In September of 2007, the talking heads/market cheerleaders talked down Augusts' volatility saying it was a one-time glitch in the markets trading dynamics that caused the increase in volatility and that everyone should start buying stocks again.  Strangely, the market got wacked again in October and November as cracks in the dam started to appear.  Ninety-five plus percent of economist stated that everything was fine.  It was commonly mentioned that corporate earnings were at record numbers, and that future economic growth is up and to the right.  "I sure wish I would have known how to short sub-prime back in 2006 when I sold my house". 

As of today, the SEC still doesn't know how, or what, caused the flash crash in May.  So what do they do? Pass rules and institute policies that are not based on fact.  I am 99.99% sure I know the reason.  It is called fear. 

The average investor got ravaged in 2008 and simply does not want to give back the gains they made in 2009.  Many of these same investors are still underwater from their 2007 equity high, not to mention underwater since March of 2000.  It is because of 2008 that many investors had to change their retirement plans to adjust to their new net worth reality. 

Europe's impending collapse had everyone's nervous finger on the trigger.  The flash crash was caused by fear, plain and simple.  Program trading may have made the drop a little worse and the recovery faster, but it was not the cause of the event.  As it turned out, August of 2007 was the canary in the markets coal mine warning of future volatility.  May 2010 was down 8.2%, and was one of the worst months in the markets history.  Was the flash crash a warning sign of future volatility?  I believe it was. 

This letter is based almost entirely on China.  Why you may ask?  Because I feel that China's equity markets are leading U.S. equity markets out of and into bull and bear markets.  At least that is the recent pattern.

China's equity markets advanced 4 months ahead of developed markets in the last bear market rally to lead equity markets higher.  Again leading, China's equity markets topped out in July of 2009 and are now down over 35%.  Industrialized countries appear to be slower out of the recovery gate, and late to roll over.  Many economists feel that China's consumption has become the economic driver of the world.  Are they leading equity markets as well?  Recent activity clearly shows that they are and if China's bubble is about to pop it deserves our attention.      

In my humble opinion, China is lying through their teeth about their economy.  Like Russia at the end of the cold war, we will soon get to see, and unfortunately experience, the bursting of the greatest bubble in human history. 

There are investors  much  smarter than me who have been saying this for quite some time.  Most of my thinking about China has come from their research findings.  In this letter, we are going to dig into their research and see if we can find clues for what China doesn't want anyone to know.  Hopefully this will give you a better understanding about our nation's largest creditor. 

Quote of the month
"It is a sad reality when a trillion dollars [in Euro-zone stimulus] can only buy you 400 points on the Dow. What can the politicos do for an encore?" - David Rosenberg

"The fate of the world economy is now totally dependent on the growth of the U.S. economy, which is dependent on the stock market, whose growth is dependent upon about 50 stocks, half of which have never reported any earnings." - Paul Volker

Our Monthly Performance Update

Baptism by fire!  In our last letter, I mentioned that we just pulled the trigger on a more adaptive way to trade equity markets.  We went live with this methodology on April 23rd, which turned out to be the very peak of the market.  So, how did we do?  We were flat in May and are up a little over 1% MTD June.  Since the launch of our new heat seeker methodology on April 23rd, the S&P 500 has declined -12.76% and we are flat to slightly up, depending on the portfolio. 

So far, I have to give our new adaptive heat seeker methodology a big thumbs up.  Below are our updated numbers through MTD June.

Below are recent performance returns on the four portfolios we currently offer:
ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Jan 08 to


MTD June







Income Builder  (IB)





The Guardian  (GRD)





Harmony Plus  (HMY)





The Expedition  (EXP)





S&P 500  (SP500)





Important Performance Disclosure


  1. Complete our Private Client Group request form by clicking here: and submitting your contact information. (This is the most preferred method.)
  2. Call us directly at (800) 731-5690.
  3. Simply send us an email to [email protected].

Someone will contact you within 24 hours of receiving your information.

China: The Economic Elephant in the Room?

It has been an incredible decade and much has changed. One of the biggest marvels has been the economic revolution in China. It has gone from a poor third-world nation with one of the lowest per capita GDP's, to the fastest growing economy in the world in a few short years.

From an investment perspective, once a follower of western markets, Chinese markets are now leading the globe in more ways than one. Chinese GDP growth, estimated to be in the double-digits this year is the best in the world with India running a close second, making both the envy of every industrialized nation struggling to repair the scars the recession left behind.  This is more than three times the International Monetary Fund estimated GDP growth for the U.S. and Canada in 2010.  In addition, roughly ten times the estimated growth for major Euro-zone economic drivers Germany, U.K., and France. 

China had no recession if the numbers are to be believed, growing at 8.7% last year while the global economy contracted 2.2%, according to

According to Economist, the IMF reckons that by 2015 almost 75% of global growth will come from China and other developing countries. This compares to a contribution averaging 40% during the 1990's, rising to 58% between 2000 and 2007.  

The Shanghai Composite Index peaked in October 2007 with other national stock markets, but then bottomed out more than four months before the other major indexes providing the first hints that the economic recovery was underway. However, since peaking in July 2009, Chinese stocks have struggled. 

So which indicator is right? The correct answer is that it is too early to tell with much certainty. Economic estimates are somewhat subjective, whereas equities markets reflect investors making real financial bets. We tend to give more stock (no pun intended) to the latter, especially considering the abysmal record economists have demonstrated in the last decade. (Ninety-five percent of economists surveyed in March 2001 got it wrong when asked by Economist if they thought a recession was imminent, even though as we later learned, we were already in one at the time!)

Figure 1 - Weekly chart of four major market indexes showing the Chinese Shanghai Shenzen Composite peaking along with the rest of them in October 2007 but bottoming well in advance of the others in spite of impressive Chinese economic numbers. So which indicator is right? Chart courtesy of

We have also described in past issues the tendency for governments to exaggerate the positive (GDP, new jobs), and downplay the negative (unemployment, inflation), when reporting economic numbers. They have a huge vested interest in making voters think the situation is better than it really is.. After all, their jobs depend on it. This is a science that has been carefully nurtured and perfected over decades, if statistical trends are any indication.

Chinese Fool's Gold?

No one can seriously dispute the fact that demand in China is strong based on the amount of commodities they are buying from countries like Australia. Much of this demand is based on export growth. According to the World Trade Organization, China exported more than $1.2 trillion in goods, overtaking Germany in 2009, making it the world's leading exporter even after accounting for a 16% drop in Chinese exports. 

How much of the Chinese ‘marvel' is smoke and mirrors? How much of the growth is the result of the totalitarian government accentuating the positives and burying the negatives so that anyone on the outside world, as well as those in the country have a distorted view of what is going on?

We've all heard that well-worn maxim, "Power corrupts and absolute power corrupts absolutely." If a totalitarian communist government with iron-clad censorship and no independent oversight, the largest standing army in the world combined with zero transparency isn't absolute power, then I don't know what is. 

Why should we care? As well as being the fastest growing economy and the largest dollar-volume exporter in the world, China now has the second largest financial system and the second largest stock market according to Economist. It is the single largest holder of U.S. Treasuries and holds the largest current account surplus. It also holds the greatest foreign reserves in the world, estimated to be somewhere between $2 and $3 trillion.

With one-fifth the population, China consumes half the cement, a third of the steel and a quarter of the aluminum produced in the world.  Perhaps more importantly, is the rate at which the demand is growing. Demand for iron ore for example, has risen by an average 27% a year in the last four years. Since 1999, crude oil imports are up 3500% and soybean exports are up a similar percentage. Copper ore and concentrate are up 2500%. (See article Ravenous Dragon).  These parts of the Chinese growth story seem real enough.

If economic growth in this dragon economy has been exaggerated by government statistics, or if the nation is in the throws of a superbubble, the global economy will be seriously impacted when the inevitable correction comes and reality sets in.

Smoke and Mirrors

Two presentations make the case that China is not only obscuring the real economic situation, but it is in a superbubble. In his April presentation entitled China - The Mother of All Black Swans, Investment Management Associates portfolio manager and director of research, Vitaliy Katsenelson breaks Chinese growth into three stages: Late-Stage Obesity (1998-2008), You Lie!, (2008 (Q4) - 2009 (Q2), and Super Steroids R-Us (2009 (Q2) - present day).

He says that the 10% growth China experienced over the last decade is unsustainable for one big reason. It is clear that western nations, and especially North America, have overleveraged themselves and now must go through a period of painful deleveraging. This has created vast overcapacity in Asia, and especially China.

For example, South China Mall opened in 2005 and is the second largest shopping mall in the world with 1500 stores and 7.1 million square feet.  It was built in anticipation that the Chinese middle class would have more disposable income. According the Katsenelson, 99% of the space sits empty. The middle class in China is only 10% of the population according to investment advisor Gary Shilling. This compares to a middle class in the U.S. of roughly 80% of the population. Such ambitious mega building projects in China are only accessible by a small percentage of the population.

Another white elephant is the City of Ordos, built in Inner Mongolia for one million residents on speculation. It too, remains empty - an expensive ghost town.

According to Katsenelson, with global exports down 25% in 2009, tonnage shipped by Chinese railroads down double digits, and electrical consumption declining, how could Chinese GDP expand 10% in 2010, and slightly less in 2011 as projected by the Chinese government? It can't, and he believes these figures are a blatant lie.

We've all heard about the massive stimulus the Chinese government pumped into their economy in the last year.  Stimulus which Katsenelson says amounts to 14% of Chinese GDP, which is the largest in the world in percentage terms.  Perhaps worse, is the fact that lending by the Chinese government (via state-owned banks) to keep the economy going, was up 250% in 2009 or by another 29% of GDP.   Most of lending was for projects similar to ones mentioned above as well as bridges, highways and skyscrapers: projects not built based on need, but to keep workers employed.

As a result of massive spending programs, national real estate prices are up 40% in the last 18 months according to the New York Times, and floor space constructed jumped 100% while the rest of the world was in recession in 2009.

Here is another example of a huge project being built in China according to the New York Times.

"In the City of Tianjin, in North China, developers have created a $3 billion "floating city," a series of islands built on a natural reservoir, featuring villas, shopping malls, a water amusement park and what they say will be the world's largest indoor ski resort."

This resort city in North- Eastern China is expected to be home to 350,000 residents but the $64,000 question is: who is the project being built for? Certainly not average Chinese. There is no way they could afford such luxuries. 

Superbubbling Over?

Frothy asset prices and growth look eerily like Japan in the late 1980's before its bubble bust. Although there are similarities, the big difference between the two Asian powers is demographics. One of the reasons Japan's malaise has lasted for more than two decades is the low birth rate and rapidly aging population; a major positive for China. All this really means though, is that any bubble burst will heal faster thanks to demographics, it won't prevent it.

James Chanosis president and founder of Kynikos Associates, an investment company that scopes out companies that are overvalued and sells shares short to profit when they drop. This strategy made millions shorting companies such as Enron Corporation. In many ways, Chanos agrees with Katsenelson.

Chanos expressed his concerns about China in a February presentation. He sees classic pockets of overheating in the economy combined with overcapacity in a number of sectors.

Chanos believes the very tight range of GDP growth estimated, that have hovered around 9% for years, is statistically "staggering." He likened the phenomenon to Soviet reports of 6-8% GDP growth, which caused many to believe it was only a matter of time before the Soviet Union overtook Western Nations. We all know what happened there.

Chanos discussed the fact that new factories are being built in China while some factories "across the street" sit idle. He says the real estate boom is due to the fact that Chinese people see property as a store of value causing wealthy Chinese to buy 3 or 4 apartments for similar reasons investors bought property in the U.S. in 2005 - 2006. The roughly 30 billion square feet of office space under construction works out to a 5x5 foot cubicle for every man, woman and child in China.

Is it any wonder why Chinese officials have been so reluctant to let their currency, the  renminbi, appreciate in response from demands from the U.S. and China's other trading partners?  If the economy is in a bubble, the last thing it needs is a strengthening currency to exacerbate the problems.

It is a stark reminder to what happened in Mexico in 1994 when investors realized that the peso had been artificially propped up and it subsequently collapsed causing an economic ripple around the world. A pop in the Chinese bubble will have widespread impact. The result could well be collapsing commodity prices and global demand for goods and services that have buoyed commodity-dependent economies in countries like Australia, and to a lesser extent, Canada, especially right now while the economic recovery is fragile. 

Chinese stock performances confirm Chanos' concerns, but more importantly have disturbing implications for U.S. stocks. As Figure 1 shows, from the bottom in the Shanghai Shenzen Composite in October 2009, to the peak in July 2010, the index rose nearly 100% before rolling over. This compares to an appreciation for the S&P500 of nearly 80% to date. A further drop in Chinese stocks would exert an even stronger pull on their U.S. counterparts. But even without the Chinese bubble bursting in the near term, further declines in global stock markets is only logical given the growing influence the Asian Tiger is having on other markets.

Trade Earnings of the Impossible Kind?

Three days after the Dow suffered what many believe was a mysterious one-day waterfall of nearly 1000 points, the world learned that four big banks, namely Goldman Sachs, JP Morgan Chase & Company, Bank of America and Citigroup, had a near-perfect trading quarter in Q1-2010. We thought it was worthwhile to put the 63 day winning streak - a period during which these giants did not lose money in a single day - in perspective. Just how statistically likely is this to achieve?

According to our very own Dr. Howard Bandy, this type of ‘luck' is far less likely than getting struck by lightning. Here is how he explains it for Goldman Sachs that enjoyed 63 winning days in the quarter.

"The probability of that, assuming each day was equally likely to be a win or a loss, was near zero.  The actual number is (0.5)^63, or, 1.08 x 1019, or 0.000,000,000,000,000,000,108." (One in more than a thousand trillion?)

Here is how he explains the chances of this happening.

"Give every one of the 6 billion people on earth a unique identification number.  Have each person pick a number between 1 and 10 billion and write it down.  Have a disinterested party select a single special person who holds the winning number and write down that person's number.  Now close your eyes, turn around three times, and name both the correct person and the number he or she picked.  That is an easier task than 63 straight winning days when winning is equally as likely as losing.

"At least three other banks/traders achieved the same result -- 63 straight -- Bank of America, JP Morgan, and Citigroup.

"So a better question to ask is:  At what level of probability for a win is it equally likely to get 63 wins in a row versus 62 or fewer wins out of 63?  The answer is 0.989.  The interpretation is that Goldman and the others each independently have a 98.9% probability of having a winning day.

"If you need to have a probability such that it is a coin flip whether the first four banks you ask all had 63 winning days out of 63, then the probability that any random day is a winning day is 99.7%."

"Certainly having low cost money to bankroll both the trading and lending operations helps."

As Dr. Bandy points out, every trader and investor, whether trading his own account or a multi-billion dollar institutional account, has these guys as competitors and counterparties.

Is it any wonder that there is a growing perception that major Wall Street firms are playing with a stacked deck? And the Federal Reserve thought it was necessary to bail these guys out to the tune of billions of dollars last year? Kind of boggles the imagination, doesn't it?

A Drop in the Bucket...

President Obama proudly announced a few months back that his politically motivated administration was committed to reducing government spending by $100 million in the next 90 days.  Here we present a short video that explains exactly what that means in terms of overall government spending and the current size of the fiscal deficit.  I hope you enjoy this presentation as much as I did.

Federal Budget Explained

Interesting reading:

Special Report; China

IMF Economic Forecast

Forecasted Growth

China overtakes Germany to become the biggest exporter of all

Risks and rewards of doing business in China

Ravenous Dragon

Not just another fake - The Chinese economy.

What does China's unloading of US securities mean?

Presentation - China - The Mother of All Black Swans

China: the coming costs of a superbubble

Jim Chanos's lecture on China

Goldman winning streak 2009

Portfolio Performance Analysis

Risk & Reward
Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below.  Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength.  Commentary found in this newsletter is for informational purposes only and does not effect how our portfolios are traded.   

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

In our last letter, I wrote the following:

"March looks like July 2009, producing multiple up days in a row.  We actually experienced 10 up days in a row in the S&P 500 futures market.  This many consecutive up days in financial futures hasn't been seen since 1987, so you might say that March is another historical reference point in a long list of statistical outliers encountered in this incredibly strong bear market rally."

It is well known that markets are hard to predict, but volatility is relatively easy to predict.  Low levels of volatility are normally always followed with high levels of volatility, and vice versa.  It is also well known that markets go down much faster than they go up.  Gains that have taken months to accumulate can vanish in a matter of weeks.  This predictive cycle has played out over and over again in the markets history.  Once the last investor has been suckered into the rally, it collapses under its own weight.  For reasons covered in the introduction to this letter, investors are in a heighten state of alert, so it makes trading this market increasingly difficult but engaging.         

Index Advantage:

Overall, I have to give our new adaptive heat seeker methodology a high five.  It took about two scary weeks for it to adjust to radically different market conditions than we experienced over the last 12 months, but once it got locked on target our trading accuracy has been exceptional.  Our exposures have been smaller than normal, but gains have been normalized by increased levels of volatility.  We are pleased so far but need more time to statistically evaluate our results in real-time, so we are watching closely.

MTD June performance 1.91

Strategic Balance:

These traders came to life in May and MTD June has been productive as well.  We recently added a new strategy trading emerging markets that has excelled at capitalizing on the trading opportunities present in this volatile market.              

MTD June performance 1.44

Dynamic Income:

High yield bonds are once again sitting on the side lines waiting for another opportunity to materialize.  From the looks of things, it may be a while before they establish new positions.  Government bonds continue to trade well and are adding gains to this important allocation. 

MTD June performance .34

Our portfolios are built using varying distributions to the strategic allocations discussed above.  To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below:

If You Are a Client, Don't Be Confused.
Actual management and performance fees are incurred monthly but are deducted from client accounts in the first month of every quarter (January, April, July, and October).  For performance reporting purposes, we deduct fees monthly as they incur and not quarterly, as they are reflected in client statements.  It all washes out in the end, but this may cause your account performance to deviate from our published performance reports on a month-to-month basis.  To be conservative, we also deduct the maximum fees we charge from our performance reports and your actual overall fees paid may be less than our maximum. 

Why Pigeons Walk Instead of Fly in Boise Idaho

ProfitScore's office used to be located at the top of one of Boise's tallest buildings.  Working downtown had some nice perks.  Great restaurants were everywhere, it was close to some really cool stuff, and I got to watch first hand the aerial attack of Peregrine Falcons as they consume downtown Boise's pigeon population.  Peregrine Falcons are serious predators, and thanks to a Professor at Boise State University, who discovered that the pesticide DDT was causing their destruction, these birds and many other birds of prey have made an impressive comeback.

Boise is home to the World Center for Birds of Prey.  This center has been ground zero for reestablishing birds of prey around the world.  My kids love to go there, so if you are in town, I highly recommend a tour.  A few years ago they had an eagle there from Panama called the Harpy Eagle that preyed on monkeys, sloths, and other large mammals.  The size of these birds made our eagles look like a school kid.  Its talons were the size of my fingers

It was not uncommon for me to be looking out my window in downtown Boise and see pigeon parts fall to the ground.  Peregrine Falcons rule the sky in Boise and thanks to the efforts of a lot of hard working people, they rule the sky in many cities across the US and elsewhere. 

Below is a webcam from a building in Boise showing a nest with three hungry chicks being fed by a mother who is thinning down Boise's pigeon population:

Peregrine Falcons are unique in that they are the only bird that kills in the air.  All other birds of prey attack their prey on the ground.  Being a pigeon in Boise Idaho is a dangerous occupation.    

Summer is here again, so I hope you have big plans with family and friends.  We are leaving next week to tour the Redwood National Forest of Northern California and spend a week on a huge houseboat on Lake Shasta with dear friends.  I can't wait. 

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

  • Complete our Private Client Group request form by clicking here: and submitting your contact information. (This is the most preferred method.)
  • Call us directly at (800) 731-5690.
  • Simply send us an email to info @

Someone will contact you within 24 hours of receiving your information.

Posted 06-10-2010 10:51 AM by John M. McClure
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