Connecting The China Syndrome With Bubbles - Part 2

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Includes: CHN, CN, CXSE, FCA, FXI, FXP, GCH, GXC, JFC, MCHI, PGJ, TDF, XPP, YANG, YAO, YINN, YXI
by: Katusa Research

Summary

The Chinese Stock Bubble update.

China's government intervention to stop the bubble from deflating.

How Chinese stocks compare to those in North America.

The Chinese Stock Market Update - As the Bubble Begins to Pop

On May 21, 2015 I put out an article about how I thought the Chinese stock market was getting very frothy ((click here for the full article)). After that, the Chinese market continued to rally for only another month until a dramatic collapse in mid-June 2015.

I never know which articles will get major attention and feedback. Connecting the China Syndrome with Bubbles P.1 was one of those articles that went viral and received hundreds of comments. Proof that I have no clue what will be "hot" because I did not expect the response I got, whereas other articles I thought were excellent received less than a third of the comments and feedback. Always learning.

Now, in late August as I wrote, the Chinese market is down38% since mid-June. But it's important to keep the headlines and facts in context. Year over year, the Chinese stock market is still up a 43% on the Shanghai exchange and 53% on the Shenzhen exchange.

The sharp drop sure created its fair share of chaos. The Chinese market panic has erased USD$4.5 trillion in value from its stock market - the equivalent of wiping seven companies the size of Apple off the face of the earth.

That $4.5 trillion is over 12 times more than has been given to the Greeks in their last two bailouts combined. It's a stark reminder of just how much more significant China is to the global growth engine. In fact, China's GDP growth creates the economic equivalent of a new Greece every three months - and that is without the debt!

Although the Greece teeter-totter makes for great headline noise, and the market has been pre-occupied by a potential Grexit from the EU, investors should be paying a lot more attention to a much larger economy with a much more significant global impact: China.

Keep your Eye on the Dragon not the Olive

The most obvious question readers will probably ask would be, "since you called the bubble, did you make any money on the short?" As I stated in my first article, I did not participate in either the Chinese market rally or the bust for one simple reason: the Chinese government. Rationally, it would make sense that if I believed the country's equity markets were tremendously over-valued I would be short. However, the Chinese market is anything but rational.

Over the last year, the Shanghai and Shenzhen stock exchanges have traded like highly volatile small cap companies on North American exchanges. And the fundamental reason for the violent swings is the Chinese government and its ever-changing rule book.

As I mentioned in part 1 of my "Connecting the China Syndrome with Bubbles" article, the Chinese government implemented a program called the Shanghai-Hong Kong Stock Connect program. It was meant to gradually integrate investing on both exchanges. This was supposedly intended to open the Hong Kong stock market to Mainland Chinese investors and open Shanghai and Shenzhen markets to international investors. Instead, the Chinese government became the largest stock promoter.

What Happens on the Shanghai, Stays on the Shanghai.

As an unintended consequence, the euphoria created by the Chinese government caused many Mainland Chinese to gamble their hard earned money in the market.

(Interestingly, gambling is an illegal activity in Mainland China, but is legal and very popular in regions like Macau and Hong Kong. Macau generated $44 billion in gambling revenue in 2014-which was 7 times higher than the take in Las Vegas. Yet, the average North American gambler would have trouble locating Macau on any map.)

In 2014, President Xi Jinping cracked down on Chinese gambling in Macau and abroad. He is strongly opposed to gambling in China and the targeting of Chinese people by outside interests. The President has cut out gambling advertising in the mainland, imposed visa restrictions, and begun tracking funds from gambling. All these efforts have reduced Macau gambling revenue by over 30% in 2015, leaving the risk-loving Chinese in search of another destination for their gambling cash.

Voilà, just in time the Chinese market becomes the next big casino. Investors are lured in to make plays on the tightening and loosening policies imposed by Chinese regulators that send stocks on a volatile ride up and down the Shanghai/Shenzhen roller coaster exchange.

U-Turns are Allowed - Dr. Jekyll and Mr. Hyde

Beijing began promoting the Chinese stock market in April 2014 with the pending implementation of its Shanghai-Hong Kong Stock Connect program. The government loosened lending requirements and encouraged retail investors in China's mainland to participate in the market upside. This caused retail investors to open record levels of margin accounts.

However, on January 18, 2015 the Chinese government decided to rein in margin lending in an effort to cool the very market it was heavily promoting, thus seemingly changing the rules on a whim.

Regulators announced that brokerages should not lend to individuals with less than half a million Yuan (or USD$78,000) in assets. This started a dramatic decline in margin lending and caused the Shanghai Composite Index to drop 7.7% in a day. It should have been the first warning to investors to get out of the market.

But, not so fast. After tightening policy on stock market lending, the government pulled a 180° U-turn and lowered the reserve requirement by Chinese banks. It also cut interest rates to stimulate the economy and promote more leveraged participation in the stock market.

The cutting of rates and reserve requirements served to push Chinese stock prices up until they reached record levels on June 12, 2015. Then regulators intervened yet again. This time, they capped brokers' margin trading and short selling ability at 4 times brokers' net capital-where previously, there had been no limitations imposed. As a result, markets fell off a cliff.

The Shanghai Composite plummeted 24% and margin trading sank back to where it was at the beginning of the year.

Does it seem to you that these folks are making it up as they go along? Well, you're probably right. Because less than a month later, on July 8, the People's Bank of China (PBOC) reversed its tightening policy on margin lending for stock purchases and decided it was going to do whatever it could to keep stocks from falling any further. The PBOC announced that it was going to lend $483 billion and the potential for an additional $322 billion to China's Securities Finance Corporation (NASDAQ:CSF) which would, in turn, lend funds to brokers to use as margin for stock purchases and outright buy stocks. As of right now, the CSF is the largest investor in the Chinese market with much of its capital deployed in large cap stocks.

CSF Corp. Holdings

This is akin to when the US Congress approved a $700 billion Troubled Asset Relief Program (TARP) in 2008 to buy assets and equity from banks - keeping them from failing. Additionally, in a concerted effort to revive the Chinese stock market, the government has resorted to some extreme measures: Halting the trading of 1,400 stocks, banning selling by major shareholders for six months, and threatening short sellers with jail time.

On August 25th, 2015 the Chinese government took made another major move to support the market. The People's Bank of China reduced the interbank lending rate 25 basis points to 4.6%. In addition, the government lowered the reserve amount commercial banks are required to hold by 50 basis points which has added the equivalent of $106 billion to the Chinese economy. These actions have been taken to stimulate a slumping economy and it may provide the Chinese with more money to pump into an already heated stock market.

Call this the start of Dragonomics. The government will do whatever it can to prevent a major sell off and market crisis.

What About Us?

US funds flow China

Over 50% of the US participates in the stock market. Meanwhile, Mainland China's participation rate has only climbed to about 10% after China incentivised new retail investors to jump in. Two thirds of new Chinese investors speculating in the market do not have a high school degrees, and more alarming, almost 9% were illiterate. Then again, the average junior mining company listed on the Canadian exchange is run by individuals with IQs sub 50.

The Unknowns about China

In part 1 of the "Connecting the China Syndrome with Bubbles" article, I had gone through all companies with a $12 billion USD market capitalization and compared US-listed and mainland Chinese stocks. The big hit to Chinese stocks has brought valuations back in line with US markets. Although a majority of industries are still overvalued relative to the US, the services and utilities industries in China are now trading in line with US companies.

US vs. Shanghai Stocks

As Chinese stock prices fall, dividend yields have risen. Even though US industries pay a higher dividend yield, the spread between the two yields are tightening.

US vs. Shanghai Yields

What My Readers Care About - The Resource Valuation of China vs. Canada

Interestingly, Chinese companies still trade at a premium to Canadian-based resources companies. To substantiate this, I went back through all the Canadian and Chinese companies with positive operating income. This time it is clear, China proved too expensive.

Canada vs. Shanghai Resources

Canada vs. Shanghai Debt

If investors believe this +35% decline in the Shanghai Composite is a correction and a great entry point, let me reiterate: BUYER BEWARE. Based on my analysis, the market is still overvalued and not in line with the Chinese economy.

China Economy vs. Market 2

By the way, for resource investors betting on China, you may want to know that there are better values in the Canadian resource sector and I'll be bringing them to you in my monthly newsletter.

But let me just add: Short sellers should also stay away!

Minus Millionaires

I collect books. Somehow over the years, I have collected and purchased thousands of books. I read a great fun read called "Minus Millionaires" just last weekend. A great takeaway from the book were the many case studies of fortunes lost by shorting the market and the government changed the rules on the individual, who was technically correct, but was ruined by the rule changes. Here is my warning to the shorters: "Even if you are right, you may lose if the government changes the rules on you". If these cases happened in the US, imagine what the Chinese government will do to shorters.

If the Chinese government has taught us anything it is that the Chinese stock market is anything but free. I believe that Beijing will do whatever it wants as long as it has the resources. It's all-powerful and unpredictable, and that's a bad combination.

Personally, I continue to remain out of Chinese markets. The risk is too high for investors, no matter whether they're long or short. Take it from someone who is, in a way, right in the middle in the China Bubble. I live in Vancouver, and if you look at the sky-high real estate prices in my neighborhood, you can see the effect of a flood of speculative Chinese money coming into the city and chasing the available properties.

Always keep in mind that we live in a connected world. The popping of the China Bubble that is currently underway will have a butterfly effect globally-in more ways than one.

-Marin Katusa

Katusa Research

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. I have no business relationship with any company whose stock is mentioned in this article.