Seeking Alpha

Michael Michaud's  Instablog

Michael Michaud
Send Message
Michael Michaud is the founder of Invest2Success.com (http://www.invest2success.com/) and the Invest2Success Blog (http://invest2success.blogspot.com/). He has been investing and trading in the financial markets since 1989. He founded Invest2Success.com to empower individual institutional... More
My company:
Invest2Success
My blog:
Invest2Success Blog
  • Short Selling The Empire Of China 0 comments
    Aug 21, 2013 7:36 AM

    Short Selling China by Dr Van Tharp International Institute of Trading Mastery

    We could debate mightily about who has the toughest trading job on Wall Street but it would be tough to argue against short sale specialists having a spot near the top of that list.

    Institutional short sellers are different from the other folks on the street who are picking names to buy. To understand just how tough it is to be a short seller in the money management world, I talked with a professional short seller.

    After considering the challenges of institutional short selling, we'll look at what one of the most famous short sellers of our era has to say about shorting opportunities related to China.

    The Trials and Tribulations of Being a Short Seller

    As a fascinating starting point, one might say that my partner, Christopher Castroviejo has short selling in his DNA. Christopher's grandfather, Benjamin Smith, was the one of the largest short sellers (if not the largest) during the market crash that started in 1929. This earned him the nickname "Sell 'Em" Ben Smith.

    For seven years, Christopher ran "short only" money for some firms and high net worth individuals who are household names. He and his firm TC Management had some amazing short side scores including Clearly Canadian and Citibank.

    I asked Christopher about the general differences between traders who short stocks for a living (like the hedge fund manager we'll discuss below) and the much more common stock purchasing manager, Christopher had some interesting and useful insights.

    Fighting the market's long-term bias. Almost everyone knows that the U.S. equities markets have been in a long-term uptrend. So putting together a portfolio of stocks that will head down takes more work and patience than finding ones that will move up along with the market. It's kind of like a salmon swimming upstream.

    Short sellers are often in positions early and have to wait. Those on the short side (and their clients) often have to have seemingly infinite patience. No one at the company wants their stock price to go down, so the efforts to keep price up often delay the inevitable for many quarters or even years. Short selling is a mental stretch for clients. Most money management clients want smooth returns, and equity curves for short portfolios are usually anything but smooth! The waiting game I mentioned above can be tough for clients to endure.

    Good short trades get crowded. When ideas start to work, "me too" traders start to pile on. With lots of short interest in a stock, short squeezes can become painful. A short squeeze happens when price rises enough that those short the stock have to start liquidating all or part of their position. Since exiting a short trade means buying the stock, this extra buying adds fuel to the up move.

    The bottom line is that successful short sellers have to do more "on the ground" research and dig deeper into a company's information to find ideas than those who are buyers. Channel checks (how much product or service volume is really flowing) require even more due diligence. Accounting reviews move from routine to full-out forensic exercises. Because of the extra due diligence, short sellers with good, long-term track records are rightfully held in high esteem.

    A Short Seller with a Record of Success

    Jim Chanos, founder of Kynikos Associates, is widely recognized as one of the best short sellers in the business. He was famously involved in uncovering the problems at Enron and WorldCom (he was, of course, short their stocks) and has had admirable performance over a very long short-selling career.

    His latest idea for a slide is the weakness he sees in China. His research into the problems with China have led him to be a very outspoken short seller of venerable Caterpillar. He says that this short was already his most profitable play for 2013.

    Chanos has made several public presentations about the problems with China and backed his position with lots research and data. Chanos' analysis is noteworthy for all serious traders and investors because China has become such an important player in many areas of the global economy that any contraction in the Middle Kingdom would have worldwide ramifications.

    Yeah, We Get It - China Is Important

    Few people need convincing that China is a pivotal player in the world economy but to drive the point home, here are some great charts by Australia's Treasury Department in 2011.

    (click to enlarge)

    It isn't necessary to dig into the details because the point is clear: China is the world's leading consumer of construction commodities by far. Thanks to its rapid urbanization and growth goals, it has become the primary consumer of base metals like steel, aluminum and copper. They are also the world's top user (and producer) of coal. The list could go on and on - but we get the picture: China's growth and consumption have been huge drivers for the global economy. If that growth sputters, reverberations will be felt just about everywhere.

    Why Chanos Doesn't Like China

    When a smart guy with a track record like Chanos repeatedly sounds the alarm, on a lynchpin to global economic health, it's at least worth a listen. To keep this piece from getting even longer, though, let's look at some of the key concerns on China in bulleted fashion:

    China's GDP numbers are suspect. This isn't the first time you've heard this (gaps from regional numbers vs. national numbers, etc.), but even with number fudging, the slide in GDP persists:

    (click to enlarge)

    China continues its overinvestment. Chanos lists some numbers like 12% too much cement capacity, 10% on steel and 18% on autos - and these are compounded annual growth rates for the past 5 years! This bleeds over into a fixed asset investment boom that's hard to fathom… The chart below shows Fixed Capital Formation as a Percent of Gross Domestic Product.

    Compare's China's fixed asset investment rate of 45% to the U.S. at 15%, Japan at 21%, and even high growth Brazil which is only at 21%. We've all heard of empty cities and huge shopping malls in China with less than 10% occupancy. And the economic accounting for the drag these projects put on the economy? About as reliable as their GDP numbers.

    All this tastily funded by a credit boom. When China tried to start some banking reforms recently, the stories of undercapitalized banks made front and center headlines which precipitated a 10% stock market plunge in two days.

    China's real estate bubble is in full swing. The affordability index for big city housing is off the charts! Check out this living expense comparison for several Chinese cities and notoriously pricey London and NYC:

    Wages are rising, putting stress on margins and manufacturing costs. This trend is pushing some manufactures to "offshore" work from China to cheaper labor markets. According to the official People's Republic of China government website (gov.cn), private sector manufacturing pay rose 16% in 2010 and 11% in 2011. Minimum wages are also scheduled to rise 13% through 2015.

    To be honest, this is only the tip of the iceberg of Chanos' China thesis. The Chinese peoples' lack of faith in government to control graft and wealth hoarding signal additional warnings.

    Cut to The Chase - What Investors and Traders Should Do

    You may not have the deep pockets and infinite patience of Jim Chanos to be able to short China-dependent stocks, but you can use China as one of your early warning "canaries in the coal mine".

    Every investor and trader should add the announcement of China's GDP numbers to their "data to watch" list. The next one will be in mid-October. In addition, realize that China related stocks, like base metal miners and most commodity related plays, should be kept on a short leash.

    Because China is a command economy, the central government has many levers that it can still pull to delay a slowdown (and to adjust the numbers so that the slowdown looks less apparent). But a lot of smart money is betting on just such a slowdown. As individuals, we'd do well to err on the side of caution as well.

    Click Here to Review More Profitable Financial Intelligence

Back To Michael Michaud's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (0)
Track new comments
Be the first to comment
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.