Keeping a Close Eye on China

A few weeks back, I made what now seems to be a very prescient call on China. As much as I'd like to convey that I am this omniscient seer of markets, truthfully, it was just dumb luck. I had no idea China was about to swan dive.

From the top a few weeks ago to the low on Monday, the Shanghai index had fallen 22% before recovering and closing at the highs of the day. However, it looks to me like the Chinese market is going to have a whole lot of backing and filling to do before it goes higher. If it shoots straight back up to the high, the risk of failing near the top is great, I believe.

If you are bullish on China, you want to see consolidation more than a methodical move upward. As I wrote this, the Shanghai was down about 2% on the morning's open in Asia. I believe this is positive for the index, as long as it does not fall too much.

I had mentioned in my post a few weeks back that I was contemplating buying a small position in long dated, deep out of the money puts on the iShares China 25 Index Fund (FXI). I have not done so, but if the index shoots right back up to its previous highs, I may get aggressive and start laying out my position.

I do hold out the possibility, however, that things could get even nuttier in China. I've been joking to my colleagues to prepare for "Shanghai 8000," or a doubling of the Shanghai index. I am definitely not advocating that people buy China right here. But knowing that things can go on for a lot longer than one can ever imagine, and that Bubbles can take on a life of their own, here are reasons why "Shanghai 8000" may be a reality in the next year or two.

The PE of the market hit 60x earnings (or so) when it topped out at the beginning of the decade. Today it is around 40x. Why not 80x?

There are more Chinese investors than there were six years ago.

There is more hot money in the world sloshing around trying to find "alpha" than ever before.

China is further along the path towards capitalism.

Profits are much higher than six years ago.

The population is richer in China than ever before.

Now, let me make this really clear - I am looking to short China (though I hold out the possibility for a short-term trade on the long side over the next year). I am not setting forth the bullish case for China. Rather, I am reasoning why the nutty could get downright stupid, like the Nasdaq 5000 c2000.

The danger with shorting China, however, is that there is no doubt in my mind that the government of China will intervene if it needs to avert a collapse of the stock market. The government in Beijing has shown great proclivity to intervene in the economy (and just about everything else) when it feels the need to attain its ultimate ends. Tens of thousands of wiped out middle class speculators does not meet the ends of the Chinese government.

Finally, I have read a number of commentators say that a decline in China should have no effect on markets in America, or elsewhere. That may be true. However, a decline in China may also be the proverbial canary in the coal mine, and may be signaling a rise in the global risk premium for financial assets, which have been squashed like a pancake, or at least until the collapse of the submerging prime market and the widening of CMBS spreads.

Comments

[huangthomas:]

On Monday, June 4 (remember what happened in Tienanmen Square in 1989), the institutional investors joined the retail investors in dumping stocks, including Chinese blue chips, in Shanghai Stock Exchange. The stocks are allowed a trading range of up or down 10%. Approximately 60% of listed stocks hit -10% and their trading was halted. The Shanghai Composite Index dropped 8.26% on that day, shy of -8.8% on Feb 27. The Chinese government immediately took remedial actions to halt the slide. It is worth while to observe the market for a while and see how the government "manage" the market. Tripling the transaction tax was intended to scare away some detail investors, but the market reaction was totally unexpected by the Chinese government.

2007 Jun 06 03:38 PM

[huangthomas:]

Here are some additional information. On June 4, 2007, the day Shanghai Stock Composit Index suffered -8.26% drop and Shenchen Componet Index was -7.76%; Hong Kong H-share Index (Hang Sheng Chinese Enterprise Index), +0.392%; FXI (H-share), -0.19%; PGJ (ADRs), -0.04%. These are the data showing how different markets respond differently to the same event. The Hong Kong market is in the same time zone as Shanghai. The FXI and PGJ are closing price in different time zone(New York) 13 hours later.

2007 Jun 06 08:25 PM