China’s hard landing

NEW YORK (MarketWatch) � Hard landing in China? Judging by the crash of a top-performing letter, it�s already happened.

Cabot�s China and Emerging Markets Report [CCEMR] caught the China boom, one of the great thermals of investing history. It racked up a multi-year record of double-digit gains that exceeded both the 15% compounded that the Hulbert Financial Digest, after three decades of monitoring investment letter performance, regards as the practical sustainable upper limit � and also the consecutive five-year streak of success that HFD thought suggested sustainability. I named it Letter of the Year in 2007. See Dec. 30, 2007 column.

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Specialized letters are like the canaries that coal miners used to take down with them because they were sensitive to poisonous gas. I kept a careful eye on CCCEMR because of my frequently-voiced, typically too-early contention that no-one really knows what�s going on in China. ( See Sept. 1, 2005 column.) And in the last two or three years, it became apparent that CCEMR was in increasing trouble. See Oct. 17, 2011 column.

Over the year to date through February, CCEMR is up 5.5% by Hulbert Financial Digest count vs. 9.37% for the dividend-reinvested Wilshire 5000 Total Stock Market Index XX:W5000FLT .

But over the past 12 months, CCEMR is down negative 24.14% vs. 4.38%. It was on my Terrible Ten list of lowest-ranked performers both last year and in 2010. See Dec. 29, 2011 column.

The impact of CCEMR�s crash has been so great that, although the letter breaks more or less even with the market over the past five years (up an annualized 1.08% vs. 1.88% annualized for the total return Wilshire 5000), over the past ten years its brilliant performance has been wiped out (up an annualized 3.02% vs. 5.08% annualized for the Wilshire.

/quotes/zigman/1859015 000001 2,260.88, -32.00, -1.40%

It�s particularly chastening because CCEMR editor Paul Goodwin had a disciplined approach, judging overall market conditions with a moving average system, which he calls his �China-Timer�, and selecting stocks on rigorously fundamental grounds.

He also made repeated efforts to diversify out of China. For example, CCEMR�s model portfolio currently holds India�s Tata Motors Ltd. TTM �and Argentina�s MercadoLibre Inc. MELI .

But, Goodwin said ruefully, his system kept pushing him back in.

Goodwin does not incline to sweeping statements about overall market and macroeconomic conditions. In his most recent issue, he merely notes that his timing system is currently bullish, although consolidating. He�s 60% invested.

However, Sinoskepticism is now so common that Goodwin does feel obliged to respond. Apparently, his subscribers have been asking him about Michael Schuman�s �Why China Will have an Economic Crisis,� which appeared in the February 27 issue of Time Magazine. See article.

Goodwin summarizes:

Schuman�s argument is that China�s brand of �state capitalism,� while it has produced remarkable results, is pursuing the strategy that built Japan and Korea into Asian powerhouses, and both of those countries experienced major collapses. Government-directed investment can indeed produce results, he says, but this will create industries that are bigger than can be justified by market demand. This will eventually lead to business failures, bad loans and a collapse in the banking sector.

�Schuman makes a powerful argument, and it�s one that we have seen stated elsewhere as �either China will collapse, or 200 years of economic wisdom will be defeated.��

Goodwin�s answer:

�Basically, so what? If a growth investor decides to avoid the market because of what might happen, he will never be in it. Growth investors make money by assuming risk. It�s that simple.�

His conclusion:

�Personally, I trust the Cabot China-Timer to tell us when China turns sour. If China melts down, we get out and move to cash, just as we did last year. There is no crisis that can ruin you if you are willing (and disciplined enough) to end your exposure.�

Well, maybe � but the fact is that CCEMR has nevertheless suffered serious damage.

However, that was then and this is now. CCEMR began suffering when Sinoskepticism was practically unknown. Maybe it will rebound now that Sinoskepticism is rampant.

In its most recent issue, CCEMR sold Arcos Dorados Holdings Inc. ARCO and Zhongpin Inc.HOGS .