Chinese Stocks: Short Targets for Accumulation Purposes?

by: Danny Furman

Despite attractive valuations and increased domestic demand, Chinese stocks haven't been able to sustain interest from investors for more than brief periods since nearly doubling in the first half of 2009. In fact, while indexes from North and South America to Europe, and even Japan, trade at the top of multi-year ranges, the Shanghai Index currently trades 25% below 2009 highs and 55% off its 2007 peak.

China's economy can be said to be transitioning from catering to export demand to domestic demand, which of course remains rather low given the conservative culture and low wages. Massive stimulus efforts implemented in 2009, afforded by excess reserves rather than adding to debt, were intended to ignite a consumer culture amidst China's world-leading population of well over 1 billion.

Inflation concerns among Chinese are rampant due to a higher concentration of consumption coming from food and energy compared to developed economies. Additionally, housing prices in developing urban areas throughout the country are notoriously unaffordable for domestic inhabitants due to speculation from foreign investors. Declining export demand, rising food and energy costs along with expensive housing have strained discretionary spending and will continue to do so until China develops fledgling demand and innovation.

China's emergence as the next economic superpower becomes more and more apparent by the day, thanks primarily to debt overload throughout Europe and North America. Still, no paradigmatic shift has been made in terms of wages among general populations of the world's many interconnected economies. It can therefore be seen that China, a communist nation, prioritizes fiscal health and sustainability rather than growth. Since late 2009 PBOC efforts have been focused on containing inflation, caused by stimulative efforts by other central banks, rather than stimulating the domestic economy.

Renowned China bull Jim Rogers has been short emerging markets for months (discussed here). As is often the case with fundamental rather than technical analysis, Jim was early to the party. Still, he managed to capture downward moves across EMs from mid-April through mid-June.

The most obvious sign of short-sellers being in control of a stock is a low-volume gap up to open trading, followed by high-volume selling taking shares below the trading range of the prior day. Patience and aggression are tremendous signs of strength. Both are exhibited when sellers wait for a stock to rise precipitously before losing momentum, then sell relentlessly. A perfect example is Netease (NASDAQ:NTES) July 7. After gaining nearly 10% the first two trading days of the month, NTES failed to rally with the majority of stocks July 6. Shares opened up over 1% on the 7th and stayed in a tight range for 30 minutes before plummeting 4% in a matter of minutes.

While short sellers appear in control of a vast majority of Chinese ADRs, I have no interest in joining them at current levels. Many investors unjustly categorize successful short-sellers as one-trick-ponies that do not trade stocks long or buy them to hold. While some may choose to focus exclusively on the short-side, most successful traders tend to play both ways - often with the same ticker symbols.

Structural strength of the Chinese economy will lead to unrivaled growth once demand is sufficient to promote innovation and increase risk appetite. Key components for growth, however, have yet to develop and leave China's economic output highly correlated with export demand.

Highly integrated multi-national corporations such as Caterpillar (NYSE:CAT) and Yum Brands (NYSE:YUM) are few and far between, despite attempts by many to lump the likes of Johnson & Johnson (NYSE:JNJ), Kimberly Clark (NYSE:KMB) and Apple (NASDAQ:AAPL) into the group. Consumer habits vary widely across different cultures, more so in terms of social behavior and hygiene than nutritional and industrial needs. Respective valuations confirm brighter outlooks for "real multinationals."

Value investors are presented with low growth and an increasingly fickle Fed in control of developed markets. Widespread single digit trailing P/Es and lower debt, along with positive trends in demographics make China uniquely attractive despite an uncertain timeframe for socioeconomic development.

The market's keenest players may indeed be shorting names like NTES to keep momentum traders from carrying prices above levels desirable to accumulate for the longer term. Similarly, recent IPO and proclaimed "Facebook of China," Renren (NYSE:RENN) was obliterated during market weakness in May and June, trading down to $6/share after reaching $24 initially. The stock is up nearly 100% in the last two weeks of trading. It appears the promising company was driven to bargain basement prices during broad market weakness by players looking to load up cheap.

Smart money "shorting to accumulate" is long term bullish, short term bearish. Investors can accordingly seek profits to the short side by purchasing short dated puts on low volume rallies and covering on any weakness. The bullish play, which I prefer in this case, would be to purchase long dated calls or shares on a pull back, expected relatively soon across global markets according to this (post) thorough analysis. Leading companies that benefit from growing domestic consumption in China, such as Baidu (NASDAQ:BIDU) and Ctrip (NASDAQ:CTRP) in addition to NTES and RENN are ideal candidates to trade long or short. For a high yielding leader capitalizing on China's growing appetite for consumption, long term investors have plenty of reasons (click here) to like China Mobile (NYSE:CHL).

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

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