Is It Time To Go Long China?

| About: iShares China (FXI)

Summary

There’s no basis for a longer term bull trend in China.

But a short-term play driven purely by investor sentiment and emotion can be very profitable.

The coming yuan devaluation is a key factor in this play.

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The price action of the Chinese equity market has created a potential bullish set-up. Now we all know that there's absolutely no long-term fundamental basis for a multi year bullish trend in China. The over levered rot under the surface of their financial system would gross anyone out. But as traders with the ability to jump in and out of the market, this is not an excuse to stay disengaged. We don't want to sit on the sidelines for what could potentially be an incredible up move - driven purely by investor sentiment and emotion. These moves are some of the most lucrative as price tends to go vertical. As long as people believe the PBoC is in control, the markets will stay supported.

Credit stimulus coursing through the veins of Chinese financial assets is nothing new. Financial bubbles have appeared in stocks, commodity futures, real estate, and now may appear in stocks again.

This stimulative binge nicknamed "stealth QE" is transmitted through the repo market and is truly staggering:

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The plumbing of the repo market can be incredibly complex, but the underlying concept is simple. One party agrees to buy a financial asset (usually a government bond) for cash. And the seller of the financial asset agrees to buy back the financial asset at a later time. These agreements are short term (think one day to one week) in nature. The goal is to add liquidity to the system and keep things running smoothly.

The question becomes how to play the long side. For people unable to trade futures, the first choice would be ASHR (NYSEARCA:ASHR) - the China A-shares ETF. ASHR tracks the CSI 300 index which includes the 300 largest and most liquid stocks in the China A-share market. A-shares are traded on the on-shore exchanges, which is where you'll see credit stimulus really have an effect.

You might be familiar with the other liquid Chinese ETF, FXI (NYSEARCA:FXI). The problem with this ETF is that it only has exposure to H-shares, or stocks that trade on the Hong Kong exchange. These H-shares will still run but not as hard as their hyperactive A-share counterparts. The H-share market is home to experienced institutional investors, whereas the A-share market can attract tons of short-term gamblers willing to buy with no risk control.

Keep in mind ASHR also has Chinese Renminbi risk. If China decides to devalue their currency, that foreign exchange loss will pass through to ASHR holders. The stocks inside ASHR are priced in Renminbi. If the Renminbi weakens against the USD by 20%, those stocks are all of a sudden worth 20% less in U.S. dollars.

To mitigate this risk we'll turn to the FTSE China A-50 futures that trade on the SGX exchange in Singapore. They have plenty of liquidity, and to make the deal even sweeter, they won't suffer losses on a Chinese devaluation. These contracts' P&L is denominated in USD which means a devaluation will most likely benefit holders. Why? Because when inflationary events like a devaluation occur, local equity markets typically react by rallying to correct for the inflation.

By using the future we get to participate in all the upside movement in the index without the currency risk. We may even benefit from the devaluation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.