Trader’s Narrative

According to Peter Brimlow from Marketwatch, the last bullish newsletter has abandoned China. The newsletter, Cabot China & Emerging Markets Report, has been the biggest bull riding the bull market in the far east to a stunning 90%+ gain in the past 12 months.

Editor Paul Goodwin recently wrote:

We’re a little self-conscious about calling ourselves BRIC (Brazil, Russia India, China) investors when all of our current recommendations are based in China…A buying panic! That’s exactly what’s been unfolding. [But] The bears have taken control! After a tremendously profitable run from the August lows, the Halter USX China Index (HXC) finally gave way to selling pressures, decisively breaking down through its 50-day moving average last week. This turns our China-Timer negative …

He recommends only one China stock right now: Suntech Power Holdings (STP). Which just happens to be one of the handful of solar power stocks that I highlighted a few months back. Since I mentioned it, STP doubled (from $35 to $70).

China’s stock market ignored all that talk in the summer about a bubble and continued to climb higher. Even a stamp tax increase imposed at the beginning of June this year didn’t impede its meteoric rise:

Usually the increase in transaction costs have been an effective way for the Chinese government to control rampant speculation in their stock exchange. See a history of previous stamp tax increases and their effect on the Shanghai market.

By reaching 6000 in mid October, the index has now multiplied itself 6 times (off its low in 2005). Yet that is still not as impressive as its last bull market in the early 90’s.

If you’re still holding on to the bearish thesis on China you have a new vehicle with which to short China: the UltraShort FTSE/Xinhua China 25 ProShare (FXP). This new ETF provides you with twice the inverse of the Chinese market. But keep in mind that that is merely its goal. It also comes with a hefty 0.95% MER. And remember, you’re going long to establish a short position!

As well, the UltraShort FTSE/Xinhua China 25 ProShare (FXP) isn’t really exposing you to actual Chinese shares. The only way I know that you can get real Chinese equity exposure through North American exchanges is through Morgan Stanley’s China A-Share Fund (CAF).

Just a few months ago everyone was wringing their hands over the Chinese stock market (myself included).

With Greenspan chiming in to join the chorus of “bubble” talk, everyone was expecting it to implode at any minute. So what happened?

Nothing.

In fact, the Chinese market is going strong (see graph below). This is remarkable considering that it has done so when almost all the global markets have corrected along with the US recently.

That’ll teach me for not using Greenspan as what he is: the world’s rarest contrarian indicator. From his poo-pooing of ARMs (adjustible rate mortgages), which are now coming home to roost, to his prediction about natural gas, to his casualness about this generations greatest financial bubble, and going back to his econometric predictions even before he was in the Fed, Greenspan has a knack for taking the wrong side of a trade. He rarely makes statements on the market, but when he does, it pays to go the other way.

Bubble or no bubble, technically speaking China looks like one hell of a resilient market.

Calling China’s Bluff
The economic war of words between China and the US hit a new shrill high note with China explicitely warning that it will use its $1.3 trillion dollar reserve to cause a crash in the US dollar if it is pushed around in trade talks. From the Telegraph in the UK:

Xia Bin, finance chief at the Development Research Centre (which has cabinet rank), kicked off what now appears to be government policy with a comment last week that Beijing’s foreign reserves should be used as a “bargaining chip” in talks with the US.

“Of course, China doesn’t want any undesirable phenomenon in the global financial order,” he added.

He Fan, an official at the Chinese Academy of Social Sciences, went even further today, letting it be known that Beijing had the power to set off a dollar collapse if it choose to do so.

“China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency. Russia, Switzerland, and several other countries have reduced the their dollar holdings.

Of course if we play this forward like a chess move, it is clear that China is in reality threatening to shoot itself in the face with both barrells. The dominoes would fall like this:

1. China sells dollar reserve
2. US dollar crashes through 80 support area
3. US interest rates shoot through the roof (bond/yield inverse relationship)
4. the wounded US housing market gets a stake through the heart
5. stock market crashes as yields shoot up
6. liquidity dries up causing a cascade
7. US economy nose dives into a deep recession
8. US recession reverberates throughout global economy
9. US imports of Chinese goods are drastically reduced
10. Europe and Asia fall into a recession (perhaps milder)
11. Chinese economy sputters
12. Chinese factories shut down causing unemployment to rise
13. rioting and unrest increases exponentially in China
14. the fan is soiled with #2 in China

Why would the Chinese put in motion the scenario which would in the end see them lose those cushy Communist Party jobs? They are not that stupid. Here’s hoping that the US politicians aren’t either.

Anyway, here’s the chart showing the Chinese and US markets:

A “stamp duty” or “stamp tax” is an archaic form of tax which is basically a prerequisite for a document to become legally binding. For example, where levied, you would have to pay a stamp duty when you buy a house to have the deed reflect the new buyer’s claim on the property. Or when you buy stocks, to reflect the new owner.

Only a few developed places levy such taxes anymore: UK, Ireland, Australia and Hong Kong (now part of China). Usually the level of the tax is left untouched. In England for example, it has been at 0.5% since 1986.

But in China not only is it levied, stamp duties are one of the dials that the communist beaurocrats love to tweak up and down. The latest “tweak” was the announcement last week that it would be tripled to 0.3% effective this Wednesday (June 6th 2007).

I showed this graph before to demonstrate that there had been an even crazier bull market in China in the early 1990’s. In this new version it shows the dates of the previous stamp duty or stamp tax changes:

I think it is fairly probable that this increase in transaction costs will greatly reduce the mania in the Chinese equities market. It may not cause a full blown crash - although the market is down overnight as I type and is at a five week low. If you want to play the Chinese market here’s how to play it from the US.

The real question now is, where will all that money flow next? You can’t dam capital. It will find its way out, one way or the other. All you can do is try your darndest to channel it.

If they ask me (and they haven’t) I would say open the gates so that the Chinese can invest outside China.

When I mentioned the bubblicious state of the Chinese market I trotted out the factoids that their indices are trading at astronomical levels relative to their respective long term moving averages (200 day).

But this sort of tell is not very reliable. For one, tops are, by their very nature, notoriously difficult to pinpoint. Unlike their counterparts, they are not borne from meteoric flashes of panic and fear. Instead, they can just peter out slowly over time.

And for another, eventhough an index can seem to be levitating dangerously above its 200 day moving average, that moving average can be hurtling up as fast to reach it. Although seemingly precarious and unstable, it can go on and on. The same way a basketball just keeps going around and around the rim and only just as everyone is tired of watching, falls into the basket.

Here are the historic extremes of indices above and below their 200 day moving average:

Nasdaq 100 Index

• in March 2000 the index was +58% above its 200 day moving average
• in April 2001 it plumbed the depth of -53% below its 200 day moving average

We all know the famous bubble top occured in March 2000. In April 2001, the market bounced from a very oversold level but only momentarily. It soon rolled over into another down leg.

S&P 500 Index

• in October 1982 it hit a maximum of +21% above its 200 day moving average
• in September 1974 it hit its minimum of -28% below its 200 day moving average

The October 1982 instance is a good example of the moving averages moving higher and catching up to the index, and reducing the extreme distance to a normal one. The SPX continued to move higher (this was the end of the bear market of the 1970’s and the start of the next major bull market).

Dow Jones Industrial

• in July 1933 the Dow reached +50% above its 200 day moving average
• in July 1932 the Dow hit its minimum of -39% below its 200 day moving average

The historic reading of oversold in July 1932 corresponds with the bottom of the great bear market of that time. And the reverse, the July 1933 reading was met with mostly range bound trading as the index slowly resumed its advance and continued to lift off the bear market low’s of the previous year.

For the historical data, I’m indebted to Jason Goepfert, from SentimenTrader.com