The Emperor's New Clothes

|
Includes: CHN, CN, CXSE, FCA, FXI, FXP, GCH, GXC, JFC, MCHI, PGJ, TDF, XPP, YANG, YAO, YINN, YXI
by: StockResearch.net

So off went the Emperor in procession under his splendid canopy. Everyone in the streets and the windows said, "Oh, how fine are the Emperor's new clothes! Don't they fit him to perfection? And see his long train!" Nobody would confess that he couldn't see anything, for that would prove him either unfit for his position, or a fool. No costume the Emperor had worn before was ever such a complete success.

Hans Christian Andersen - The Emperor's New Clothes

Long-time readers will know that we have been skeptical of China for many years. A corrupt, insular government run by men solely focused on maintaining their power and privileges at the expense of the people they govern is not a suitable manager of an economy. And yet, they try. And fail. Over and over. The "Chinese Miracle" that sycophants like to gush over while they hold their hands out for contracts from the state-run enterprises is a mirage. Chinese companies have issued $21 trillion in debt in recent years, much of it to finance inefficient, uncompetitive businesses that wouldn't be able to survive without regular, large doses of new debt. The economy of China is walking around without any clothes, and yet they think they are a great success.

For some reason, the IMF recently admitted China's currency to the top echelon of global reserve currencies. They stated that China was making moves towards an open economic system in which the renminbi would be freely exchangeable into other currencies. Ah, no they aren't. A recent article in The Wall Street Journal noted that immediately after receiving this designation, the inner circle of the finance ministry congratulated themselves for a job well done and turned their attention to weakening the renminbi against a basket of 13 currencies in order to boost their export economy. Free markets? Hardly. But once again, the IMF and others don't want to admit the obvious - that China is still a manipulated economy controlled by a statist, Communist government and large, state-run enterprises. It is not a free economy on par with those of Europe, the US, or Japan. The government basically borrowed its way into its current position, and so long as it pegged its currency to the dollar, it could control that debt and its economy. But when you open your currency to the world and allow it to be valued based on fundamentals, a funny thing happens - you lose control. Either your debts go bad, or you continue to print more money to pay them, which in turn makes your currency less valuable. It is this dynamic that the central planners missed. They would be better off remaining a closed system in order to continue to fund their debts internally by simply printing more money. By then, controlling their exchange rates, they could manage inflation and export balances. However, the prideful rulers decided that they wanted the status of a world power, and in order to be admitted to the club of first-world economies, they were willing to sacrifice some control over exchange rates. This vanity is now coming home to roost.

The ruling party has limited choices. They maintain power by creating an aura of invincibility and infallibility. Criticism of the government is prosecuted and repressed (I'm guessing I'm not going to China anytime soon now). When the market is going up, it's because the government is doing an amazing job of managing the economy and generating growth. When it goes back down, this same government accuses brokers and fund managers of manipulation and fraud. Numerous heads of companies and brokerages have gone missing recently - not week goes by now when the Financial Times doesn't have a story on a CEO who is suddenly "unreachable", and no one knows where they went. Sometimes they reappear a few days or weeks later, without commenting on their disappearance. Sometimes they don't reappear at all. Want to do business in China still? I don't. See this article I wrote back in 2011 on the issues in the Chinese economy and tell me if you do.

But he hasn't got anything on," a little child said.
"Did you ever hear such innocent prattle?" said its father. And one person whispered to another what the child had said, "He hasn't anything on. A child says he hasn't anything on."
"But he hasn't got anything on!" the whole town cried out at last.
The Emperor shivered, for he suspected they were right. But he thought, "This procession has got to go on." So he walked more proudly than ever, as his noblemen held high the train that wasn't there at all.

Hans Christian Andersen - The Emperor's New Clothes

On Thursday, China's cabinet held an emergency meeting about the failed circuit breaker system that the country's stock market implemented on Monday and canceled Thursday night, after it clearly didn't work. At the meeting, held "in the walled Zhongnanhai compound where China's top leaders live and where few ordinary Chinese have ever set foot" (The Wall Street Journal), Xiao Gang, chairman of the China Securities Regulatory Commission, was grilled about the failure of the system he had championed. For a government that needs to appear infallible, the fast fall from grace is unacceptable. The Chinese markets have been revealed to the world as the farce that they are. They have quickly gone from being an economy held in awe to one viewed with derision. Social media in China, to the extent the posts are allowed to remain online, has been filled with mocking references to the government. If I was able to, I'd short Mr. Xiao's career at the top of the Securities Commission, and will not at all be surprised to find him the subject of "corruption" charges or the victim of an untimely accident before the end of 2016. The Emperors are beginning to shiver in China.
______________________________________________________________________________
This week's first two Trading Rules are a repeat from last time, because they are very timely given that trading in China's stock market is 85% retail investors, and they appear to be panicking...:

  • If you're going to panic, panic early.
  • Retail investors often panic later, and for longer, than market professionals expect, creating larger crashes than the fundamentals dictate.
  • Fear is a powerful emotion. When people are afraid of losing their savings, they do things that "rational" investors don't expect, causing losses for those that are caught in their way. When this fear permeates markets that have gone up for a long time and are no longer cheap, it can spread incredibly quickly.

China is coming unraveled, and the central government's attempts to rescue its markets over and over will eventually fail. At some point, it will either own most of the outstanding shares available on its stock exchanges or have to abandon its strategy of propping up its markets. Eventually, if it wants to have open markets, prices will move to where investors again become interested in buying. I suspect this level is so far below where the markets are trading today, especially given that no one trusts the government anymore, that either the government will have to close trading for an extended period of time or allow both the stock and currency markets to reset lower in a large, fast move. I'd bet on the latter.

SPY Trading Levels:
Support: 188/189. That's it.
Resistance: 195, 200, 204.5/205, 209/210, 213

Positions: Long and short U.S. stocks and options, long CEFs, long SPY and IWM Puts.