Was China Behind Thursday's Market Sell-Off?

In an article that I posted two days ago, I posited that market commentators should not be so quick to dismiss the sell-off in China as having little if any effect on American markets. I stated that a declining China could cause a rise in global risk premiums and lead to a decline in asset prices around the world. Another aspect is even more straight forward - simply that the Chinese government is selling U.S. bonds, and using the funds to buy Chinese stocks.

I have no idea if this is true or not. It is merely conjecture. However, this scenario is certainly possible.

The Shanghai Index (FXI) was down 22% top to bottom before recovering a few days back, with the market gapping down to the low then recovering to close at the daily high. Since then, the last few days have been relatively stable while western markets have been getting cracked. When I wrote this, the Nikkei was down 300 points, Shanghai had barely budged, but still, somebody was in a buying mode.

I have been reading reports that there have been demonstrations in China, even riots, as investors who'd hocked the house deeds to pawn brokers charging 3% monthly interest in order to play the market are very under water, and are reacting as one might expect people to react, if those people had bet everything on a seemingly one-way ticket that turned out to be very multi-directional.

The Beijing government - whose first and foremost priority is survival - has every incentive to assuage the potential homeless thousands by supporting the market. A belief in free market capitalism is way down the totem pole for the members of the Politburo. If the government of China believes its best interests are to support the market, it certainly will. As for the argument that it is not in China's best interest to tank the dollar by dumping T-bonds, that may be true most of the time, but if the government believes it is threatened by social unrest, it will do what it has to do now and worry about the consequences later.

After all, China owns $1.2 trillion worth of dollar reserves. And if you look at Thursday's action in the Treasury market, someone was desperately selling.

That is a big, big move in the bond market.

I pondered this scenario for much of the trading session, and was told by a bond guy whom I met on the way out of the office on Thursday evening that there had been aggressive selling of agency debt, i.e. Freddie Mac and Fannie Mae, out of Asia today.

Frankly, I have no idea. But the real action was in bonds, not stocks.

Stocks, though, did not escape the slaughter, especially in some of the hot sectors. Take a look at the utilities

That is a big move for utilities.

Look at what the industrials have done.

Look at the REITs, which I am short on.

Real estate has to hold near here, baby, because we've already cut through the 200th day like it was butter. It is a long, long way down after we break that (weak) level of support at $79.

I am essentially net flat in my portfolio, with only one short relative to the rest of my equity longs. That short is my position in long dated puts on the Real Estate ETF (IYR). As I have been saying, REITs are stupid here, trading at a 40%-60% premium to stocks when they should trade at a discount. With the cost of financing going up, that is a dangerous cocktail.

Also, look at the banks.

And, look at the brokers, as well.

Neither one is really healthy.

And frankly, the proverbial canary in the coal mine, gold, doesn't thrill me either.

Weak retail comps and higher oil prices were also factors in the sell-off, but the main driver was the violent rise in interest rates.

Alas, though, there is no need to worry. Helicopter Ben will come to the rescue, I am sure. This seems to be his wont whenever asset markets get in trouble, just like his predecessor, Easy Al. It is the reflex of the Fed to bail out investors for their mistakes. No matter that spreads are at record lows in emerging and junk bond markets, the economy is too reliant on keeping asset markets afloat.

I do not think this sell-off is The Big One. Maybe it is, I don't know, but the run in stocks since July has been very methodical, not manic. I am inclined to believe there is a frothy stage yet to come. But perhaps that froth won't come to U.S. markets. It may be manifesting in emerging markets instead, as China and others have been highly speculative.

I believe this is the much awaited near-term pullback I keep yammering on about. I think we will yet see higher highs during the year. Then sometime by the end of 2008, you'll want to be far away from stocks as possible.

I don't think we're there yet. But if we are, bring it on!

Comments

[CrossProfit]

China is fighting a trade war on two fronts.

With all the negativity sprouting up this week, coincidently coinciding with US trade deficit reporting, China chose to heighten the trade tensions by firing back at France and the United States at the same time.

It is still not all out war, yet signals that China will no longer take any verbal bashing by trading partners. Chances are that the French will back down as they always do, leaving the US in a funny predicament entailing numerous possible outcomes.

In any event, this was very clever of the Chinese as picking on France and scoring a capitulation further strengthens their hand with the EU and the US. Ironically this could backfire if the French hold their ground. Who are we kidding, the French haven't held their ground since WW-I! Score: 1-0 China.

This was the reason behind Shanghai's action and this is the reason the rest of the markets are behaving as they are. First, all Chinese sensitive markets react. Markets with little exposure to China have yet to react. They will react to the reaction of other markets as a chain reaction. All in good time.

Then again, trade issues may vanish into thin air.

We don't buy the general assertion that the EU interest rate hike has anything to do with the market action. First, it is amazing how short the memories are of some people. The EU rate hike was well anticipated in advance. Second, the current action started way before the hike. Third, the Chinese market is driven by the Chinese and the Chinese government; not Bernanke. The dual action, fees and rhetoric, is what Shanghai is reacting to.

Disclosure: This is the opinion of CrossProfit analysts and reflects the majority opinion at CrossProfit.com.
www.crossprofit.com

[john gaats]

It is amazing peopel are using such a long text and numerous charts to distort facts. We know pretty well what behind Thursday's sell off. China stocks are holding pretty well during the sell off.

[john gaats]

FXI is not Shanghai index.

[Nidhi]

Interesting possibility of Chinese government selling US bonds and buying their own stocks to help its people. Either this possibility is a temporary action OR the chinese government will be misleading its own people. Because for chinese govt to invest in its own market, it should believe that chinese stock market is undervalued or at least decently valued. But Chinese officials have already mentioned that their market is overvalued and have increased their tax on stock transactions (from 0.1% to 0.3%) to reduce stock market activity and hence the over valued situation.

creating-wealth.blogsp.../

[S Powell]

Why would the Chinese government need to sell anything to buy Chinese stocks? Last time I checked Chinese stocks are traded in CNY, and the Chinese government can print up as much CNY as they like.