Paint China by Numbers

Developing a market bias for a particular market is very similar to a paint by numbers picture. You can see the outline of what the picture is with a quick glance but it's not until you start to fill in the colors that you really begin to see the entire picture in vivid detail and can appreciate all of the nuances.

 

Market Bias

It’s important to develop a process for evaluating both the fundamental and quantitative picture for a particular market and then turning that evaluation into a Bias of LONG, SHORT or NEUTRAL. 

A LONG bias indicates that both the fundamental and quantitative picture are bullish and we believe a particular market will rise in price. 

A SHORT bias indicates that that both the fundamental and quantitative picture are bearish and we believe a particular market will fall in price. 

A NEUTRAL bias indicates that the fundamental and quantitative pictures are not aligned (one is bullish and the other is bearish) and a particular market currently has an unclear direction and should be avoided. 

The goal of the market bias, over time, is to capture the majority of the prevailing trend in a particular and, more importantly, “catch the turns” and alert investors when the current trend ends and a new one begins.

 

Fundamental Assessment

 Your process for evaluating the fundamental picture for a market will be dependent on that particular market.  However, your fundamental analysis for all markets should include a thorough geographical understanding. 

Here are a couple of the factors you want to monitor:  the current economic conditions of the geography where your Market exists, the current monetary policy, the state of interest rates and the local currency.

All investments exist in a particular geographical area and it’s important to monitor and understand the state of that particular economy.

Now that you’ve painted in the numbers of the fundamental portion of you market’s picture, it’s time to determine if the quantitative picture (price movement) of your market is bullish or bearish. 

 

Quantitative Assessment

There are a million ways to determine the direction of your market, however, the two simplest and most effective are moving averages and trendlines.  Whether you choose to use moving averages or trendlines, it's important to be duration agnostic.  You should monitor each market over multiple time frames, not just one.  I don’t look at any trend less than 2 months in duration and I monitor all of my markets over 3 time frames: 2-6 months, 6-12 months, and 1 year or more. 

Monitor your markets over at least 2 time frames.

Now that you’ve painted in the numbers of the quantitative part of your market’s picture, you’re ready to rate the Market Bias for that particular market. If both pictures are bullish, then the market gets a LONG bias. If both picture are bearish, then the market gets a SHORT bias. If one picture is bullish and the other is bearish, then the market gets a NEUTRAL bias.

 

China

Since October 27, 2014, I have carried a NEUTRAL bias on Chinese equities, via the FXI exchange-traded fund. Since that date through the close of business this past Friday, FXI has rallied 10.8%. So, for the last 11 weeks, I’ve been dead wrong on the direction of Chinese equities. There are 2 questions to be asked and answered. Why stay with the NEUTRAL bias?  Will I be wrong over the next 11 weeks?

 

Chinese Fundamentals

Given the process I use to develop a market bias, there is a very straightforward reason why I have carried a NEUTRAL bias on Chinese equities during a 10% rally.

The fundamental picture is showing something very different from the quantitative picture.

Remember, when you evaluate the fundamentals, what matters most occurs at the margin.  Here’s a breakdown of the economic trends across the more critical data series to evaluate the Chinese economy:

1.      China Manufacturing PMI- peaked last July and has fallen for 5 consecutive months and is hovering just above contraction at 50.1. Above 50 indicates expansion, below 50 indicates contraction.

2.      China Non-Manufacturing PMI – peaked last May, fell for 5 consecutive months and has increased a total of 0.3 points in the last three months.

3.      Chinese Industrial Production (YOY Growth %)- peaked in August 2013 and has been in a downtrend ever since. It bottomed in August at 6.9% yoy growth, rallied in September up to an 8% yoy growth rate and has now fallen for 2 consecutive months back down to a 7.2% growth rate.

4.      Chinese Retail Sales (YOY Growth %)- peaked in November 2012 and has been in a downtrend for the last 2 years. Retail sales year over year growth hit a short-term peak on a bear market bounce back in May and have since fallen for 6 consecutive months.

5.      China Newly Built House Prices (YOY Change %)- peaked in January 2014 and has now declined for 12 straight months and have been negative, year over year, for the last three consecutive months.

I didn’t cherry pick these stats to fit my bearish outlook on China, rather all of that data I have seen out of China has informed the bearish outlook.

I could have listed another dozen indicators all with similar downtrend profiles and more specifically, accelerating lower during the second half of 2014.  So, now that we have painted in the numbers of our fundamental side of the picture, lets started painting the quantitative side.

 

Chinese Equities

Over the past 6 months, as the fundamentals in China are painting a picture of a slowing economy, Chinese equities, FXI, has been trading its way back up to its post-Crisis high at 43.08, which it hit back in November 2010.

As of Friday’s close, FXI is trading at 41.68, a mere 3% from that previous high. This rally has been fueled entirely by the belief that the dismal fundamental data will force the PBOC to step in with even more easing measures than they have already initiated.

But it's not just foreigners who are aggressively bidding up Chinese equities. The Chinese people themselves are getting in on the action, at a historic pace.

Last week there were 900,000 new brokerage accounts opened, that’s the most in over 7 years. Interestingly enough, the last time that many brokerage accounts were opened, the Shanghai Composite declined 70% of the next 9 months.

It should be pointed out that while the FXI is up over 10% since October 27, the Shanghai Composite, which is a stock index of all stocks that trade on the Shanghai stock exchange, is up 41% over that same time frame - 41% in a little over 2 months.

In Q3 2014, Chinese banks saw a net outflow of deposits for the first time since 1999. In fact, people are moving assets into the stock market and out of savings accounts at such a large clip that banks are offering cash rebates, trips abroad, even free vegetables to entice Chinese savers to deposit their yuan in savings accounts.

One Shenzhen-based bank in October, offered an iPhone 6 Plus in lieu of interest payments for depositing 38,000 yuan for 5 years. For depositing 903,000 yuan for the same period, savers could pick one of four Mercedes-Benz models. A Mercedes A180, which costs 252,000 yuan, would give investors the equivalent of an annualized return of almost 7 percent, compared with the benchmark rate of 4 percent on 5-year deposits. Speculative fever anyone?

 

Recipe for Disaster

Slowing fundamentals and a feverish need to rush into an equity market simply because it has already gone up a lot and no one wants to miss the opportunity. So, why not a SHORT bias instead of NEUTRAL?

I learned the hard way not to SHORT markets that are ripping the way the Shanghai Composite and FXI have been ripping the last couple of months. I’ll wait for the quantitative picture to show a hint of weakness before shifting to a SHORT bias and attempting to cash in on the inevitable correction.

Interestingly enough, the imbalance in Friday’s price action of FXI is generally just such a weakness. Historically, that type of imbalance has been a signal of the beginning of a decline.

I’m not quite as quick to rely on it because it occurred at the end of a 2-week stretch of thinly traded holiday markets but it is something I will be watching very closely this week.