Trader’s Narrative

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)

You know, I’m tired of people calling the US market a “bubble” or using words like “melt-up” or “buying panic” to describe it. These sort of pessimistic adjectives belies the bearish sentiment still pervasive in the wider market. If you want to see a real bubble in the making right now, you needn’t look far: China.

The Shanghai Composite has been on a rampage. Since bottoming in the summer of 2005 it has risen ~300%. Just recently, it hit a bump earlier this year and since bottoming in early February 2007 it has risen 50% (and counting). No matter how you look at it, China has gone parabolic.

The US large caps, which are currently leading the market, have put in a tame performance by comparison. They’ve only returned about a tenth of what the Chinese markets have. Still want to call it a bubble?

Keep in mind that I’m comparing the Shanghai Composite to the Dow and not the Shenzhen. That would make the comparison even more ridiculous since it has risen ~70% since its February 2007 bottom. By the way, this short term “speed bump” in the Chinese markets gave the world markets quite a jitter, if you recall.

Click to enlarge graph:

I’m not concerned about the US markets. But I am rather very concerned about what the Chinese bubble could mean for them. Technically speaking, the Shanghai market could fall 1000 points or about 25% and still be in a long term uptrend. How do you think the world markets would react to such a drop? what if it comes in a very short time?

The other reason I’m concerned is that the Chinese market, unlike the US markets or any of the other well established global financial markets, are riding on fumes. There is no substance behind the companies. Most of them are shells. The banks are in terrible shape. And most of the demand is internal with Chinese funnelling millions of Yuan towards a thinly veiled form of gambling.

When the Chinese bubble ends in tears (and it will… they all do) the Chinese market’s correction back to reality will effect the US markets more than anything stateside. This is something most people, both permabulls and permabears, are not yet cognizant of.