Alibaba: Initial Phase Of Rally Is Drying Up

Summary

• Alibaba stock has become one of the main drivers of the Chinese stock market, returning 35.6% since December 30, 2022.
• In global terms, I would like to draw investors' attention once again to the risks that have faded into the background.
• The initial phase of the rally in Chinese equities is almost done. Hedge fund positioning seems to be consistent with this view.
• In my opinion, Alibaba stock is more likely to fall in case of capital outflow from Chinese stocks.
• Looking for a helping hand in the market? Members of Beyond the Wall Investing get exclusive ideas and guidance to navigate any climate. Learn More »

SOPA Images/LightRocket via Getty Images

Introduction & Thesis

Since the beginning of 2023, the theme of China reopening has attracted many investors to Chinese stocks - the iShares MSCI China ETF (MCHI) is already up 12.5% YTD.

Alibaba Group (NYSE:BABA), which is 9.46% of this ETF, has become one of the main drivers of the Chinese stock market, returning 35.6% since December 30, 2022, well above many other stocks of the region:

Data by YCharts

In all the time I have been writing on Seeking Alpha, I have written 9 articles about Alibaba stock. At first, I was bearish (the first 4 articles), then my tone changed to neutral (the last 5 articles). From the first bearish article to the first neutral article, BABA fell 25%; from the first neutral article to today, the stock is trading 5% higher.

In the last article - "Alibaba's Asset Structure Is Another Reason To Stay Aside" - I discussed the company's asset structure and explained why BABA's low multiples can by no means be the only factors potential investors should pay attention to.

After such an aggressive bull run that we have seen in the incomplete 1st month of 2023, I would like to draw the attention of potential investors once again to the risks that I believe many have begun to suppress.

In addition, BABA is showing signs of slowing down and reversing the trend - it is time to take profits if you have participated in the rally.

New Rally, Old Risks

As I have been writing in almost all my previous pieces, Western investors should exercise caution when considering buying Chinese stocks, including Alibaba, due to some factors not applicable to Western capital markets.

One major issue is - still - the VIE structure [variable interest entity] used by many Chinese companies, including Alibaba. This structure allows foreign investors to invest in a company operating in China in a restricted industry, such as technology or media, through a contract rather than as an owner. This means that the non-Chinese investors do not actually own the assets of the company or have control over its operations, and instead, rely on contractual arrangements with a Chinese entity that holds the assets and operates the business. Lately, I have increasingly noticed that investors have started to talk less about it - the narrative has changed toward reopening.

Even if you are willing to pay not for the company itself, but for a contract from an intermediary company - how sure are you that the financial data on paper is true? Retail investors' talk of this risk has died down somewhat since the Public Company Accounting Oversight Board recently gained full access to inspections and investigations of Chinese companies for the first time in history [December 15, 2022] - that was an additional bullish catalyst to the main one from "the great reopening news". However, it still needs to be borne in mind that Chinese companies are not subject to the same level of regulatory oversight and disclosure requirements as companies listed on exchanges in developed markets such as the U.S. or Europe. The lack of independent auditing and accounting standards in China makes it difficult to assess the true financial condition of Chinese companies.

Another reason to be cautious about investing in Chinese stocks, including Alibaba, is the increasing authoritarianism of Chinese President Xi Jinping. Xi has consolidated his power and suppressed dissent, leading to concerns about human rights and political stability. I like the way Michael Green from Simplify Asset Management described the potential consequences of the political movement that has gripped China since it began consolidating power in such a vast and populous country in one hand:

My take on China, and I've argued this for a while now, is that China operated under a very simple principle. You don't protest, we will make you rich. And the minute you can no longer make people rich, you can't actually rely on that. And so you have to stop them from protesting in a different way. To me what's transpiring in China is a very simple reflection of what is called the political J curve, right? Where you migrate to stability. There are really only two forces, two places of stability, you either have an incredibly successful society in which people are broadly so happy that nobody really wants to get particularly worked up and disrupted, with some exceptions as the United States. The second form of incredible stability is effectively North Korea. And so China, while we had hoped that they were going to migrate towards us, instead is very clearly migrating back towards North Korea.

Source: Michael Green [emphasis added by the author]

The new geopolitical reality in which we have been living for some years is bipolar. The deglobalization processes are forcing Western countries to seek independence from their Eastern partners - especially when the latter start violating international law, as Russia has done. As I see it, China is trying to sit on two chairs - not to lose the American sales market, but also not to quarrel with its nearest neighbor and a country that is politically very similar. This is a dangerous game that many have lost sight of - again, the issue of reopening and its influence today is enormous.

Globally, however, I believe, China is opposing America both politically and economically and is trying to wrest dominance from it. Therefore, I feel that Western investors are betting against America by supporting Chinese capital markets [buying stocks is one way of doing so], and even Warren Buffett would not approve of such behavior.

For 240 years, it's been a terrible mistake to bet against America, and now is no time to start.

Source: The Motley Fool

By and large, I decided for myself a long time ago that I see no reason to invest in the Chinese economy despite low valuation multiples and growth potential because a) multiples can quickly lose relevance if your company is pressured by the state, and b) operational growth can easily be replaced by a steep crash with the click of a regulator's finger. Any of the above options is possible in any country, but China seems to me to have a higher chance of this happening. Moreover, emerging markets as a separate geographic area for investment seem too large to bother with a country where so many problems have accumulated and where ideology itself will be a limiting factor as the leader has absolute control over everything.

Okay, what about BABA?

I remain neutral despite the above risks. Chinese consumers trapped in their homes during parts of the pandemic amassed more than $2.2 trillion in bank deposits last year, which should boost spending, according to the Wall Street Journal [January 22, 2023]. This is positive for Chinese equities in the medium term.

However, as noted by analysts in Morgan Stanley's Asia/Pacific quant strategy team [information is taken from ZeroHedge], both active managers and asset owners - sovereign wealth funds, family offices, etc. - tend to believe that the initial phase of the rally in Chinese equities is almost done. Hedge fund positioning seems to be consistent with this view, as data for the 1st half of January show that hedge funds have increased their short positions in the financials, technology, and communications services sectors by double-digit percentages.

Morgan Stanley [January 24, 2023]

This momentum is only visible to professional market participants - retail investors are still willing to chase the rally in BABA and other Chinese stocks, according to socialsentiment.io data:

BABA stock, socialsentiment.io

In my opinion, Alibaba stock is more likely to fall in case of capital outflow from Chinese stocks.

First, BABA has grown more than all Chinese large caps - I showed that above. BABA has only 2.16% of all stocks outstanding sold short [YCharts data] - still quite low.

Second, we cannot ignore the seasonal factor. Since its IPO [14 years ago], BABA stock has struggled to grow in February, March, September, and December. In its worst month of the year - December - BABA fell nearly 80% of the time, with an average decline of -6.6% MoM. In 2022, BABA broke this rule with an MoM growth of 0.61% in December.

Seasonality has expired but not disappeared - if the first wave of stock growth is indeed behind us [as Morgan Stanley's team thinks], BABA will most likely see a decline in February and March, which is very close.

TrendSpider, BABA, seasonality

The third moment that can indicate a depletion of demand for BABA is the RSI divergence on the daily chart. Other momentum indicators, such as MACD, suggest a possible pullback in the price shortly:

TrendSpider, BABA, author's notes

The same can be seen on the 4-hour chart - in the medium term, BABA looks rather weak today:

TrendSpider, BABA, author's notes

The fourth point to pay attention to is the illusory nature of valuation multiples. If we look at the Non-GAAP price-to-earnings ratio, it seems quite low - only ~15x, which is the lower bound of the historical norm for BABA stock. However, this forward multiple should become a TTM one once the company shows astronomical recovery growth - that is already priced in:

Data by YCharts

Bottom Line

In global terms, I would like to draw investors' attention once again to the risks that have faded into the background.

I suspect that many investors who bought BABA in recent months will want to take profits in the coming weeks - this is consistent with seasonality, technical setups, and hedge fund positioning. The narrative of China opening up still sounds like a strong argument for BABA, but it's probably losing momentum already and may lead to weakness in the medium term. Low multipliers and reopenings alone are not enough to risk your hard-earned money.

Thanks for reading!

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.