Trader’s Narrative

How’s this as a strange contrarian indicator for the Chinese stock market? This is a billboard advertisement for Yinji Shopping Mall in Zhengzhou featuring a hanging mannequin next to a graph of the stock market:

The agency behind the billboard explain that they are making fun of the Chinese stock market. In Chinese, the billboard reads:

It’s better to invest money here than put it into the stock market.

What I’d like to ask the agency is why do they have the graph going up if they are making fun of the market’s fall?

The Shanghai Composite has fallen 72% from its high on October 16th, 2007. Compare that with 45% for the S&P 500 Index (from its high on October 2007 to the low in October).

This mention of Chinese stocks in the most recent edition of Barron’s caught my attention:

We have 10% of our equity holdings in companies outside the U.S. We have a huge database covering 59 countries and every stock with a market cap of more than $200 million. One of the countries that looks really interesting is China. There are still 214 Chinese companies that have more than $1 billion in market value. The mean P/E on those stocks, as of last week, was 13, down from a peak in 2007 of about 56 times.
In China, you are going to see slower gross-domestic-product growth of maybe 5% or 6%, down from 9%, but there are some extremely attractive values there. And although people say you are trying to catch a falling knife, the Shanghai index is down 75% from the peak in October of last year. So China has become our largest holding in terms of emerging markets.
Steve Leuthold

Leuthold is one of the “greybeards” - market players who have seen and know a lot. So you’ve got to respect his views, even if you don’t defer to them.

Way back in May 2007, much too “early”, I began to suspect the Chinese equity markets were in a speculative bubble. When the Chinese government increased the stamp duty, for all intents and purposes, it was the death knell for the Chinese stock market. It took a few months and prices went parabolic in those final months - as they always do just prior to an implosion.

Previous bear markets:
Measured by the Shanghai Composite, here is a list of previous declines from the year the market topped to how much it fell:

1992 — 72%
1993 — 77%
1994 — 49%
2001 — 55%
2008 — 72% (so far)

Here are a few ways to get Chinese exposure:

• Morgan Stanley’s China A-Share Fund (CAF)
• Taiwan Greater China Fund (TFC)
• The Greater China Fund Inc. (GCH)
• China Fund Inc. (CHN)
• JF China Region Fund Inc. (JFC)
• SPDR S&P China ETF (GXC)
• iShares FTSE/Xinhua China 25 Index (FXI) — Edit: thanks Greg

All except the last are closed-end funds, so they may not trade at their NAV. Also, CAF is the only way I know that outsiders can get in on the A-Share’s market.

The last time I revisited the Chinese stock market, it was in the throes of a major bear market. Fast forwarding to now shows things have only intensified with the Shanghai composite trading at less than half of its top in October 2007:

While we quibble about a percentage point here and there to see if our market decline fits into the classic definition of a bear market, there are no qualms regarding that in China.

Support?
The scary thing is that even after falling so much, the index is still far from major support areas. If you look at the link above, you’ll see a long term chart of the Shanghai composite going back to its founding. According to that chart, significant support is somewhere in the vicinity of the 2000 level. That would put a potential fall to almost 70%!

I have no idea if that will happen but the Chinese stock market certainly has precedent. It is not for the faint of heart. The Shanghai Composite can go ballistic: rising as it going ten fold in the span of a year (1991-1992) but it can also lapse into deep stagnation, as it did from 2000 to 2007, treading sideways.

Dire Portents
But what interests me more is the portent of such a dramatic decline for the price of crude oil. From what I read, China holds significant responsibility for the current price of oil because of its voracious appetite. But if the stock market is a forward discounting mechanism, that means that the Chinese economy is about to decelerate or even go into a tailspin.

The corollary of that is lower demand for oil and, if I remember Economics 101 correctly, that would mean a lower oil price - all things being equal.

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:

Finally! The S&P 500 finished the day at 1530.23 - an all time high. Everybody was watching this level as it had been the line in the sand, drawn more than 7 years ago:

On March 24rd, 2000 the S&P 500 reached an intraday high of 1553 (red circle above). And for the next few months kept trying to go higher but each time it was pushed back.

In hindsight we know this level to be the last bull market top and the blow off of the internet bubble of 2000.

The interesting thing to note is that not only did the S&P 500 put in a very strong performance today, it did so in the face of some seemingly bearish cross-currents from China. Overnight, the Chinese authorities tripled their stamp tax on stock transactions in another attempt to cool the mania surging in their stock market. The Shanghai market dropped almost 7%. The last time China sneezed like that, we caught a cold (February/March 2007).

But now? We seem to have developed an immunity.

I find it still supportive that so many people, even active traders and investors, are in denial of what is right in front of their quote screens. I’ve already covered how the retail “Mom’n'Pop” investors are simply not interested. But I’m seeing much of the same from many experienced, knowledgeable market participants. They simply do not want to believe this is a bull market.

Which is more the reason why it is. And more reason why it has some ways to go.

Finally, we may very well see the market correct from this level and go into a range bound contraction as it digests the resistance. That would only be natural. In the medium to long term though, I think we are headed higher.

As I wrote yesterday, on that time horizon, it is foolish to bet against the house.

The Chinese government is actually taking measures to try and control this crazy market of theirs:

• Widen the trading band of the yuan against the dollar to 0.5%
• Up lending rate to 6.57% & deposit rate 3.06% (now just above inflation)
• Raise reserve requirements by half a percentage point by June 5th 2007
• Allow up to 50% of bank assets to be invested internationally

All of these measures are meant to reduce the liquidity sloshing around the Chinese economy (which is finding its way into the stock market). Another positive step they could take would be to allow short-selling but I’m not holding my breath. They already do not allow margin trading so all this mania has been created by fully paid up shares. Can you imagine what it would be like it gamblers, er, I mean investors were allowed to use margin?

To give you an idea of the bubble like action on the Chinese stock market, lets look at it from the point of view of long term moving averages. When the Nasdaq bubble topped on March 10th, 2000, it stood at 5048.62 while its simple 200 day moving average was at 3259.71. In other words, NASDAQ was appx. 54.88% above its long term moving average.

Right now, the Shanghai Composite is around 65% above its 200 day moving average and the Shenzhen Index is 86% above its long term moving average !!

Meanwhile, over in the US, the Dow Jones Industrial is a tame 10% above 200 day moving average and the S&P 500 is around 9% above its MA.

So how can you play this crazy Chinese market?

ok, lets try this again In my last attempt to list the Chinese securities available in the US markets I missed a few…

Thanks to a kind reader, I’ve been reminded of the existence of an exclusive way you can access the otherwise off limits Chinese A-shares. As you know, normally the A-shares are restricted to Chinese nationals but Morgan Stanley has negotiated a small quota of a few hundred million as a Qualified Foreign Institutional Investor and made it available on the NYSE.

An important distinction to note: Morgan Stanley’s China A-Share Fund (CAF) is not an ETF nor does it track an index. It is an actively managed portfolio structured as a closed end fund. And as such it can deviate quite a bit from the Shanghai and Shenzhen indices. It may also trade at premium/discount to its net asset value. And it does.

Right now CAF trades at a discount of 17.35% to its NAV. This is surprising when you consider the scorching performance of the Chinese markets and that this is the exclusive vehicle with which international investors can participate. Perhaps it has to do with the way the fund has lagged the indices:

As the chart shows, CAF has not kept up with the Chinese indices, lagging more than 50% behind the Shenzhen market. Also notice how it took the February 2007 correction much harder than the indices themselves. Unfortunately, “active management” isn’t contributing very much here.

On the plus side, if you’re thinking of shorting CAF, it could fall much faster than the Chinese indices.

Other closed end fund with Chinese exposure are:

• Taiwan Greater China Fund (TFC)
• The Greater China Fund Inc. (GCH)
• China Fund Inc. (CHN)
• JF China Region Fund Inc. (JFC)

and another ETF that I forgot to mention:

• SPDR S&P China ETF (GXC)