I'm a contrarian by nature. Resisting the crowd and groupthink comes naturally to me. I believe when it comes to investing, you need 4 skills to be a successful contrarian.
1. You must be able to understand what's wrong with people’s behavior.
2. Resist the psychological pitfalls that cause most people to make mistakes.
3. You must have a solid process for determining the value of a particular market and never waver from that process.
4. You must buy when people are selling and sell when people are buying.
It’s also helpful to remember that short-term moves in markets are always based on investor sentiment and technical considerations but long-term moves always occur because of the underlying fundamentals of that market.
The price movement and developing fundamental picture in China over the last couple of months exemplifies this last point. There was a ton of attention paid to copper getting hammered on fears that there's a wave of credit defaults coming to China which will impact a number of investment trusts that have been sold to investors.
Whether this “wave of defaults” actually occurs and to what extent it impacts the Chinese economy remains to be seen. While it’s certainly important to be aware of the developing situation, I think it’s premature to spend too much time analyzing the situation.
Mainly because no government controls capital the way the PBOC does. It has a number of tools at its disposal for moderating the impact of such defaults. And frankly, if the defaults do occur it only plays into our SHORT bias.
Look At The Margins
There seems to be a lot less attention paid to some key developments that point directly to the intermediate- term direction of China and further confirm my SHORT bias for Chinese equities (FXI).
China started the week by reporting the second largest trade deficit on record. Exports declined 34% month-over-month and 18% year-over-year from January to February. This decline caused the $23B surplus in January to turn into a $32B deficit in February. The lunar new year was blamed for distorting this data as exporters ramped up before the holiday while importers boosted activity just after the holiday ended.
That said, the fact remains that if you combine January and February figures, exports experienced the largest decline since 2009. I discussed the potential for weak export numbers in the trade commentary section for FXI in the February 17 report. I discussed my skepticism of the unusually robust export and import numbers that had been reported in the previous week.
I went on to say “I think it’s interesting that Chinese officials reiterated a 7.5% target for export growth rate given the huge January number. Either they know the number is inaccurate or they're expecting weakness in international trade. Either way, last week’s data hasn’t changed China’s growth trajectory.”
I’m not saying I have a crystal ball but I hope I’ve impressed upon you once again that everything that matters in financial markets occurs at the margin.
You can gain a significant edge if you're able to piece information together more effectively than other market participants.
Other data points which continue to show a slowing Chinese economy were retail sales, industrial output and fixed asset investment which all reported slowing year-over-year growth rates from January to February.
In addition, both the official and HSBC manufacturing numbers slowed month-over-month hitting an 8-month low. How did markets respond to this bad data? Chinese equities, FXI, sold off 5.6% on volume that was approximately 70% above the weekly average.
Watching FXI over the last couple of weeks is a perfect example of how markets digest information.
And Still Short China
I’ve had a SHORT bias on FXI since January 20. Our most profitable trade idea since I started publishing The Whaley Report, was the SHORT trade idea in FXI that was initiated on January 22 and closed on February 5.
As it turns out, February 5 turned out to be the lowest point for FXI since last July, until last week.
So what happened in terms of fundamental data and price action from the low on February 5 until last week’s meltdown?
From a fundamental perspective, all of the data over the last couple of weeks has continued to paint a picture of a slowing Chinese economy. Here are a couple of snippets from the trade commentary section for FXI from several reports since FXI bottomed on February 5.
February 10- I discussed the weakening manufacturing and services data and then go on to say that “China and the rest of the emerging markets look poised for rtuher downside from a fundamental perspective as well as technical one.”
February 17 – I was skeptical of the robust export and import data that had been reported in the previous week.
February 24 – “The data is still indicating that FXI and most of the emerging markets warrant being traded from the SHORT side.” I also note that we missed the entry price for another SHORT trade idea by 15 cents. In hindsight, missing a trade idea by 50 bps hurts a lot given that FXI has fallen nearly 9% since that day.
March 3 and March 10 – I maintained my SHORT bias in light of FXI rallying from a price perspective but fundamental data not confirming such a move.
So the fundamental picture didn’t change for FXI, yet it managed to rally 8% to the intraday high on February 19 and it had rallied 6% from the Feburary 5 low to the start of last week’s heavy selloff.
This type of divergence occurs very frequently. And we're given many opportunities to use short-term price movements based on investor sentiment and technicals to position ourselves for the larger price movements that occur over months as markets move towards their underlying fundamentals