Trader’s Narrative

Last week we reviewed the white hot Chinese stock market with a cautionary note. I wanted to return to it briefly because the situation is serious and deserving of much more attention.

Putting aside price charts of the Chinese equity market for now and turning to monetary measures, we can see something rather alarming happening. China’s M2 has enjoyed a constant rate of acceleration as shown in the chart below (in semi log scale). But in late 2008 the rate of acceleration suddenly increased dramatically:

This was a consequence of the massive stimulus plan put into motion by the Chinese government. They pumped unprecedented amounts of liquidity into their economy to offset the world-wide economic slowdown. There would be nothing singularly alarming about that since all central banks around the world, as well as governments in charge of fiscal policy, have orchestrated a collective burst of activity.

What is alarming is that the Chinese economy, stock market and especially real estate market are just now displaying bubble-like characteristics. The government controlled banking sector is a mystery wrapped in an enigma. No one can begin to fathom the amount of non-performing loans on the books. Unlike the US which went through a gut wrenching cleansing - thanks to the largess of the lobby-less taxpayer, the financial sector is once again back in fighting shape (privatized profits, public losses). China has yet to address their toxic assets

As we briefly touched on before, since last year’s low the Shanghai market has now appreciated more than 100%. Once again the stock market has enthralled the average person in China with thoughts of wealth and the possibility of making more in a month than what they earn in a year at their regular job. Speculation in the market is seen as not only a legitimate way to make money but a very lucrative one with low barriers to entry.

A sure sign of a bubble is extreme turnover. Recently, the total Chinese stock market turnover (in one day) reached $63 billion. That’s more than the combined total turnover of $58 billion in London, New York and Tokyo for the same day!
Continue reading ‘China’s Bubble 2.0 Threatens Global Recovery’

While the US market has been incredibly strong, the Chinese stock market, by comparison, makes it look downright flaccid.

A few months back we looked at the Shanghai Stock Exchange Composite and noticed that the Chinese equivalent of the Coppock Curve had turned positive. As well, just a few weeks before this long term signal was given, we had another important positive development: a golden cross. Since then prices have climbed in what can only be described as a trend followers dream.

That was a good place to go long Chinese equities (green up arrow). Since then the Shanghai Composite has climbed by 37%. But if you were reading this blog way back in early November 2008, I wrote about the extremely negative sentiment in China towards stocks and how this was a great contrarian indicator.

Back in November 2008, the Shanghai Composite was trading around 1700 - pretty much nailing the exact bottom (green up arrow). With the Shanghai Composite now trading at 3438, that’s 100%+ in 9 months.

So obviously, everyone all of a sudden loves Chinese stocks now. Their IPOs are popping like crazy. Just today China State Construction Engineering opened at 6.70 yuan, well above its initial public offering price of 4.18 yuan and closed on heavy volume at 7.30 yuan. It is telling about where the future global epicenter will be when the largest global IPO so far this year is Chinese.

A good old IPO frenzy is a sure sign of a sentiment extreme, just like billboards lampooning the stock market are a contrarian indicator at the bottom. But there are other signs of caution.

The last time the Shanghai Composite closed this far from its simple 50 moving day average was way back in October 2007… just as the market was making its top at slightly under 6100. And the last time the index closed this far above its 200 day simple moving average was in November 2007. Again, not a good time to be long this market.

Also, notice that simple support and resistance highlights this level as congestion going back to the spring of 2008. As prices were falling last year, they were met with strong support around this area. The Shanghai Composite thrashed about as prices disturbed their smooth downtrend. So this same area is now resistance as it acted as support before.

There is no question that things are really stretched at this point in Chinese equities. Of course, price can always continue but if you’re sitting on nice gains, it doesn’t make sense to continue to ride them as the odds are now totally skewed against you. The time to go long Chinese stocks was when no one wanted them, late last year as I pointed out back then.

From a long term perspective, having being blessed with both the “golden cross” and the Coppock Guide upturn, the best is yet to come. But not before we have a pull-back to shake out the weak hands. So unless you are ready to ride so major turbulence, it would be smart to lighten up here and ring the cash register.

If you’re not going to listen to me, consider Jeremy Grantham; who was correctly pessimistic and called the bear market as well as the spring rally this year. In his recent report, the chief investment strategist at Boston-based institutional money manager GMO writes:

Deciphering the strength of the Chinese economy will also play a major role in formulating our view of any future relative strength of emerging. My colleague, Edward Chancellor, strongly suspects that the Chinese economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors. On the other hand, the strong longer-term case that I outlined in “The Emerging Emerging Bubble” 15 months ago seems intact. I suggested then that emerging equities would sell within fi ve years or so at a distinct P/E premium to celebrate their obviously superior GDP growth compared with that of an aging developed world. Emerging market equities are already selling at a modest premium to EAFE and the higher quality half of the U.S. equity market.

Being pro-emerging yet anti-China is a dilemma for us; we are working to resolve it. Meanwhile, emerging equities, like most risky asset components, are moderately overpriced. We in asset allocation may, however, push our luck in emerging – particularly ex-China emerging – using inertia to reduce our current modest overweight. If we do this, it will be out of respect for the high probability that emerging equities will sustain and increase their overpriced level relative to the rest of the world.

You can download the complete report from Jeremy Grantham from the FREE Trading Resource Section (in the Reports folder). There is a lot of other stuff you might like as well, so take a look around.

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.

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).