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The Blessed China Rally 2015Q2

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2015Q2 Letter for Investor #3 - 2015/6/6 - Futron Investment

Full PDF version can be downloaded here.

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The Blessed China Rally

2015 June 6th

This 2015Q2 newsletter was written on the first week of June. It had been a little over four months since our last newsletter. Our A-share fund was up +46% during the first five months in 2015, while our benchmark index CSI300 was up +37% during the same period. China A-share market had caught world-wide attention since the beginning of the year. Like many investors around the world, we were repeatedly shocked at the strength and speed of this China rally. In our last newsletter, we had a year-end target of 4500 points in the CSI300 index. We were happily humiliated when the market surpassed our yearly target in just the first four months. With the strong blessings from the China central government, we continue to hold our optimistic outlook for the China A-share market. We believe the current bull rally will far surpass and last much longer than all its previous cycles. Many investment peers doubt our optimistic and we are fully aware of all their concerns. We hope to address them accordingly in this newsletter.

Global Macro and US

Our outlooks for the global macro and US market have remained the same as we stated in our last newsletter. To avoid repetition, please refer to our last newsletter if interested. The highly anticipating interest rate "lift-off" is still on the table this year and it will continue to "cloud" every investment decisions around the world. Although both the US unemployment and inflation targets are on course to meet the rate hike requirements, raising interest rate this year will most likely hurt the slow recovery. So, we believe the chance of rate hike this year is low. At this point in time, the upside in US market is very limited but the downside is enormous. After six years of consecutive positive returns in the S&P500 index, the risk-reward ratio in the US market is now skewed into highly unattractive zone.

The Gamed Market

Ideally, a free market economy is one based on supply and demand with little or no outside intervention. Every products in the free market are transacted freely with buyer and seller agreeing on a mutual price through a price discovery process. A free market also reflects true asset pricing based on discounting all its future incomes or other fundamental valuations. All modern economic theories that we were taught in school are based on these fundamental principles.

Yet, since 2008, the market reality seem most contradicting to everything we learned in school. Countless money printing QE programs by the FED have bought up all the available bonds in the market, keeping interest rate at the ultimate near-zero level. Unlimited capital are being lend across the globe, distorting and inflating prices in every asset classes. By now, it should be crystal clear that the reality of the sluggish US economic recovery will never be truly reflected in the market because stocks indexes now only reflect the change in size of the FED's balance sheet.

Looking deeper into any asset classes such as equity, bond, currency, rates and commodities. Something else is wrong in all the markets because only speculators and computers are involved. Our digitized price discovery process in modern exchanges are being gamed and manipulated by computers spamming, spoofing, stuffing price quotes at light speed. These problems are so vivid, yet the honorable SEC blindfolded their eyes domestically and arrested an E-mini S&P 500 futures day trader across the ocean, blaming him for the historical flash crash back in 2010. After seven years, we are still wondering why we haven't of any arrest or conviction responsible for the US subprime loan crisis.

New investment vocabularies are added to our investment dictionary every day to reflect new market phenomenon such as the new term "Phantom liquidity", which reflect the reality that market liquidity is usually there 95% of the time when you don't need it, and can suddenly vanished for absolutely no reason when you most need it. Costly slippage is now a new reality, our trades are always filled by computers front-running us. The funniest thing is when a US old colleague showed us how he managed to get a better filled "bid" price, by selling first at two ticks lower and then buying it back twice the volume simultaneously.

On the bright side, our jobs as investment managers for the past few years were actually getting simpler. Everything we were taught in school on economic was lost. Everything we learned about fundamental valuations were not applicable. The only thing left was our faith with the FED, and the belief that they had the power to control and resolve everything. Don't laugh! This simple strategy of following and front running the FED had been very rewarding for the past six years. However, the US market has finally reach the moment of truth, the systematic risk of interest rate hike and market illiquidity has finally caught up in the game.

The War Games

Cyber wars and currency wars has started many years ago between countries. Yet, from 2015 onward, we must add one more type of war in our radar, the potential of physical wars between countries. Throughout our human histories, when economic is bad and geopolitically get messy, war is the ultimate solution to resolve both. It's inconceivable nowadays to have a war at home, but it's not so inconceivable to have a war in other people's backyards or some distant islands.

Everyone recently talks about the idea of the next "Big Short". We want to be more creative and give you a "Big Long" idea: GOLD! In the past, China has absolutely no reason to disclose their official physical gold holdings, which they had been secretly accumulating all these years at low cost. However, China might be forced to disclose their real holdings by the IMF before the Chinese Yuan can join the SDR (Special deposit right) basket in early 2016. In another world's most populated country, India government has just announced a new policy offering interest payment for physical gold deposit at banks. Shocking but clever, India hope to monetize the +20000 tons of unproductive gold asset owned by individual households. When both the dragon and elephant start playing the world's biggest currency poker game with their gigantic gold reserves, gold can no longer hide in the dim corner. To echo Kyle Bass and many other great hedge fund managers: "Gold is the ultimate hedge against all the idiocy in our world's central bank policies".

The Hong Kong Market

US interest rate hike expectations together with the US dollars appreciation cycle represent a frightening combination to any experienced HK investors. We have witnessed this pain numerous time in the past. The HK stock market is traditionally controlled by foreign investors, and every strong US dollars cycle will cause massive capital outflows, causing big volatility and a painful correction in HK market.

Without a doubt, HK is now becoming a major battleground between traditional foreign investors and the new incoming China investors, each with completely opposite outlooks and expectations. Traditional foreign investors used to control every aspects of the HK market, commanding big rallies and leading big IPOs. Nowadays, their market throne is being challenged everyday by the China investors. The recent controversy around Hanergy Thin Film Power Group Ltd, 566.HK, is a perfect example of such battle between the two groups.

Ruthless China investors had been pushing an unproven solar technology company to an unimaginable level of +HKD$350 billion market capital in less than a year. Then, while the old boys from Wall Street crushed their stock by half in a morning, timing it perfectly when their top managements were in the middle of their annual shareholder meeting press conference. The stock was halted since then.

In the first five months alone, we have witnessed China investors trying aggressively to push the HK market higher with a tailwind from the A-share rally. However, traditional foreign investors are selling out, suppressing the market mainly due to concern of the strengthening of the US dollars and the coming rate hike expectations. Unsurprisingly, massive amount of capital from both sides will continue to collide and cause much higher volatility in the HK market.

The upcoming mid-June approval of the nomination process for the new 2017 HK Chief Executive Election holds the ultimate key to the future of HK. HK's society is deeply divided and the government is struggling to move forward. If the nomination process is not approved, the muddy cloud above HK's future will get even darker and this will continue to puzzle HK investors for the remaining year. Despite a +15% gain for the year in the Hang Seng index, we continue to hold a conservative outlook for the HK market. Unless we see a sudden change of attitude from the non-bullish foreign investors or the successful approval of the nomination process, we expect the HK market to trade sideways between 26000 to 28000 in Hang Seng index for the remaining year. And between HK and China market, we believe China market still holds a bigger opportunity this year.

The China Market

Unlike other more developed markets such as US or HK, China A-share market is relatively young and is distinctively different, with unique market structures, characteristics and behaviors. It is an understatement to say that our investment decision process in China is completely different than our investment approaches in US or HK market. China's financial system is a close-looped market and the China's central bank has absolute control over the whole system. Let's not take this fact lightly, China's central bank probably has multiple times more controlling power over China's financial system than the US government, FED, Goldman and JP Morgan combined have over the US financial system. A closed financial market with a mighty central bank is actually not as bad as it might sound. When all the biggest banks, insurance companies, retirement funds and state-owned funds take direct orders from the same boss, reading between lines and predicting market trends are much easier for investment managers. Just like in the US market, correctly figuring out and front-running central bank's intention already win you half the game.

With detail planning and incremental adjustments, China government is carefully jiggering everything within its financial and political powers to move forward the country's economic master plan. Deleveraging the debt level that currently kidnapped the whole financial system while rebalancing the economic structure to a more sustainable growth model and maintaining social stability are the top priorities of the China government. It will take at least a decade to transform China into a consumer economic, but the direction of economic reform is very clear. During the past two years, efforts on anti-corruption, political and public-related reforms are slowly gaining supports and confidence among Chinese citizens. We are quite optimistic that the current government has the determination and execution power to sail through the many coming storms, leading China into a better future.

Without a doubt, all China economic indicators are currently pointing toward a downward economy with property oversupply, slow exports and weak consumption. Yet, the country can no longer afford to boost economic growth by increasing infrastructural investments like they used to in the past. They need to find a new way to boost economic confidence and buy more time for economic soft landing. As learned from the US since the 2008 financial crisis, inflating the long overdue bearish stock market is the quickest and easiest way to help boost the much needed economic confidence.

As investment professional, we are paid to generate alpha returns under any market circumstances. We really shouldn't get too involve in the "cause" but spend more time on the "effect". When every big and small policies announced in the past 18 months from China central bank have lined up perfectly to hint at a government-engineered stock rally, it is just plain wrong not to concur and hop on the train. With interest rate cut, massive liquidity, easily available margin credit, and mainstream media heating up the herds, the China market rallied fearlessly. Like most investors around the world, we were also surprised at the speed and magnitude of this rally. But, at this moment, we are not worried about the bursting of the bubble. We are confidence that the China government will continue to release more and more easing policies to help soft-land the slowing economic, which will further support and extend this bull cycle.

Like the US market, by now it should be crystal clear that this China stock rally is not due to any economic fundamental, but due to its central bank's intentions and the amount of liquidity available to push the market even further. It is an undeniable fact that the country's central bank wants the stock rally to create an overall wealth effect, which help cover up all the holes in the real economy. We are certain that the China government wants to have the stock rally to last as long as possible, or at least until the real economic engine picks up again. The mad bull is now running wild and they need to tame it before it runs out of room. To massage the rally, restricting the "demand side" or liquidity of the market is very dangerous because it might accidently kill the bull. So, the more ideal approach is to control the "supply side" of the market, poking small holes in the giant water bubble. Since the start of the year, China government had been working on many different ways to create more supplies to absorb the excessive demands in the market. On a side note, China has by far the highest saving rate in the world, an estimated of >30% disposable incomes are lockup in banks saving account and term deposits. So, there are trillions in liquidity parked aside, enough to buyout the entire market multiple times over. Armies of under-invested and missed-out investors are all anxiously waiting on the sideline, ready to jump in whenever there is a big pullback in the market.

China domestic IPO market has become the world biggest IPO market in 2015. China National Nuclear Power Company, the country's second biggest nuclear power operator, was recently oversubscribed 143x times, locking up CNY$1887b (USD$303b) of fund for its CNY$13.2b (USD$2.12b) IPO. This is just for one IPO offering. China is now regularly approving dozen of IPOs every two to three weeks. Each new group of IPOs locks up approximately CNY$5 trillion to CNY$8 trillion of fund, equivalent to ~USD$1 trillion of liquidity. The China government knows that these pending IPOs are barely enough to soak up all the excessive liquidity in the market. So, they are also working on a new registered scheme for IPOs, aiming to release more IPOs at a much faster pace.

The revision of the foreign investment law will also allow companies with Variable Interest Entities (VIE) structure to return back to the China market. This mean that all those famous internet companies listed outside China such as Tencent, Baidu, and Alibaba can be re-listed at home soon. And needless to say, the return of the Alibaba Group is the most keenly anticipation by the country's investors in this bull cycle. In fact, if the VIE law restriction is waived off, as planned in the next few months, we would bet that this bull cycle can last until the day we see Alibaba listed on the China market. That's how strong we felt the China government, specifically Premier Li, wanted to see this happen.

Billion dollars' worth of new stock issues and bonds are being approved weekly, at a much faster pace than in the past. Clearly, the Chinese government has many ways at hands to deal with the "supply-side", poking small leaks at the giant water bubble both safely and effectively. Finally, before the whole bull cycle come to end, they will try their best to export the bubble. How? FTSE, MSCI, Vanguard and many other global funds are all planning to add A-shares to their emerging markets index. And for the first time, the new exchange connections between China and Hong Kong will allow oversea investors to invest in A-shares directly.

China now has their smartest and brightest financial peoples in the country working endlessly on their financial master plan. All policies announced are carefully planned and calculated on their net effectively. One of the country's ultimate goal is Chinese Yuan liberalization in the next five to ten years. The Chinese government is not so naïve to solely rely on the virtual economy. They are also working hard to push their "One belt, one road" or "New Silk Road" master plan. Everyone knows Chinese state-owned companies are the world's best at building infrastructure, because they are the world's fastest and cheapest. With the newly announced Asia Infrastructure Investment Bank (AIIB) providing the necessary funds, exporting infrastructure development is their best game on the book. It's a dream come true for undeveloped countries too, who doesn't want a new port or a new railroad at home fully funded by foreign investor? It's just like the US subprime mortgage loan for the poor, countries with light pockets will all eventually take the bait. And of course, we will then see another big infrastructure bubble, but that's a story for another time.

Opportunity for Foreign Investors

By now, everyone knows ChiNext index is averaging 130x times earnings, Shenzhen index is averaging 60x times earnings, and Shanghai index is averaging 24x earnings; whereas, Hong Kong Hang Seng index is averaging 12x times earnings. It's a mad world out there in China and many lagging peers are asking us how to play catch-up. Let's look at some mind-blowing facts:

We included HK in our greater China stock market capitalization because more than half of HK-listed companies are in fact based in China or co-listed in there. China is currently the world's second-largest stock market in term of total market capitalization. With IPOs rolling out non-stop every week and US-listed mega companies returning home, China market has the highest growth rate among all. Its total market capitalization could easily double in the next five years, surpassing the US market.

China is also currently the world's biggest stock market in term of monthly trading volume, more than double monthly trading volume in US market. The last column indicates the monthly trading volume over market capitalization. Notice that the Shanghai and Shenzhen markets are both trading at a mind-blowing +50% turnover each month, meaning half their total markets are flipped each month! Please keep in mind that most state-owned shares are not traded, so the total available floating share tradable is roughly reduced by half. Therefore, in reality, the entire available floating shares are, in fact, being flipped at least once each month. And with the highest retail investor participation rate, China's market is by far the biggest and hottest gambling casino in the world. As an investment professional in a near-zero sum game, what else can you ask for? In your investment career, can you afford to miss such an "once-in-a-lifetime" opportunity?

China is still a relatively immature market with limited supplies (of stocks) and excessive demands (of liquidity). When China central bank fired the starting gun with a rate cut seven months ago, the market jumped ~50% in the last 30 trading days of 2014 and it jumped another ~40% in the first five months in 2015. Statistically, the previous four bull cycles in China went up on average by +300%, and the volume in this bull cycle is roughly 4-5 times more than the last one. So, we strongly believe that there is both the fuel and the room for this bull cycle to run. Up until now, with CSI300 index hovering at 5000 level, we believe the first wave of the rally (the easy money) is over. The market will slow down with some healthy 10-15% pullbacks in the third quarter, before making new highs again at the year-end. The key point to remember is that the China's government want to keep the bull market running, but at a much slower pace.

Of the three markets that we focused daily, we believe China still offers more profitable opportunities and better risk-reward ratio than the HK or US market. Of course, there are still many individual opportunities in all markets. But, our overall market preference for the remaining year are: China > HK > US. The HK H-shares index is a good way to take some exposure to the Chinese market because it is currently trading at 12 times earnings, half the valuation of their co-listed A-shares counterpart. But be mindful that HK is a very mature market, the H-shares index will never catchup with the A-shares index.

For the average US investors who want an exposure in the China market, the best strategy is to split your China position into 4-6 trades, go long and diversified into one of those popular China ETFs or HK H-share ETFs when there is 5-10% pullbacks in the market. For more sophisticated investors, another good strategy is sector rotation by using China's sector ETFs. As we mentioned in our last newsletter, sector rotation in China is highly cynical and very profitable. The two main profit drivers for our A-share fund are sector rotation and event-driven strategies. China market is extremely sensitive to news and policies, and we have often been forced to take profits earlier than we wished. Drawdown management is a key benchmark in our fund performance and we hope to achieve a much lower drawdown ratio than our benchmarked index before year- end.

This newsletter is getting a lot longer than expected, we will leave our discussion on hi-tech valuations in the Chinese market and the "New Third Board" for our next newsletter. Lastly, if you can only remember one line in our newsletter, please take our most sincere advice when investing in China - "Never bet against the Chinese government".

Futron A-Share Fund NAV:

http://xueqiu.com/futroninvest/profile

Futron Investment Profile on Xueqiu.com:

http://xueqiu.com/S/P000128

Futron Investment Profile on Seekingalpha.com:

http://seekingalpha.com/user/40362166/profile

Email: info@futroninvest.com

Sincerely,

Eugene Lau

Futron Investment (HK) Ltd. | 2015Q2 Letter for Investors

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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