The Greatest Teacher

I’m a firm believer in the proverb that “experience is life’s greatest teacher.”

You can read or watch videos all you want about a subject but you can’t really learn how to do something until you actually attempt it. And you can’t excel at a subject until you’ve experienced a lot of what can go right and wrong with it.

Trading is no different. You can read every trading book and take every video trading tutorial, if you’re immortal, but you can’t replicate or replace the knowledge that comes from trading real money in real time.

Period.

If you haven’t been paying attention to what's happening in China over the last 12 months, then you’ve been missing out on a valuable experience that can help you become a better trader.

 

The Recap

From May 2014 through the middle of this June, the Shanghai Composite, which is the Chinese equivalent of the S&P 500, increased 155%.

This huge move occurred in conjunction with further easing policies by the PBOC, increasing margin debt and fervor for stocks by the Chinese retail investor and an overall deterioration in all of the economic numbers that matter.

During this time period, I carried a NEUTRAL or SHORT bias for FXI, one of the Chinese equities ETFs, for 80% of the 59 weeks of this rally. Price action and underlying fundamentals have to be in concert for me to carry a directional bias.

The fact is that Chinese fundamentals were negatively diverging from the bull market for most of that time. I’m not really breaking any new ground here. Anyone who has watched markets for the last decade know how high markets can run in the face of downright horrific fundamentals when a central bank is more than happy to provide all the liquidity and an implied “put” underneath an equity market. The current learning opportunity comes from what has happened in the last 4 weeks since the Chinese equity market peaked.

 

The Kitchen Sink

The Shanghai Composite has lost 25% of its value in the last 4 weeks. It has lost the equivalent of 15 Greece's in terms of market cap in just the last 3 weeks. The Composite is experiencing daily volatility like it hasn’t experienced since the Financial Crisis back in 2008.

Chinese officials have thrown everything they can at the stock market in the hopes of stabilizing it. The extent to which the government is going to stop the stock market decline is mind blowing here are just a couple of the extraordinary steps they have taken. They have temporarily suspended all IPOs. They set up a “stabilization” fund which was funded by the largest 21 brokers.

This fund, which holds about 15% of the brokers’ assets, will invest in blue chip stocks. The top executives at the largest asset management firms have promised to not sell any of their stock holdings for at least 1 year.

Just last week the PBOC promised to provide liquidity support to the CSFC, which is the clearing house for all margin financing and stock lending business in China. The CSFC is the only provider of margin financing services in all of China.

As if that wasn’t enough, the government has apparently banned the media from using terms like “equity disaster” and “rescue the market.”

Are you kidding me?

It’s also been reported that China’s police will investigate any reports of “malicious” short selling of Chinese equities. So now, betting on a decline in equities is a punishable offense.

As if that wasn’t enough, last week it was reported that Chinese brokers were actually refusing sell orders from investors. Has anyone seen the movie “Boiler Room?” You can’t make this stuff up. 

Don’t forget that it was just the prior week when the PBOC lowered rates for the fourth time in 7 months. It cut the reserve ratio, the lending rate and the deposit rate. How did the equity market respond?  The Shanghai Composite has fallen 10% since the announcement.

The bottom line is that despite all of the extraordinary measures taken by the Chinese government, the stock market continues to fall.

 

Fundamental Impact of a Crash

There are two ways that a stock market correction could significantly impact the Chinese economy.

The first is consumption. There are about 258M stock trading accounts currently open in China that’s the equivalent of 80% of the entire US population. Keep in mind that almost a third of those accounts have been opened in the last 9 months.

There has been a major shift of assets from bank savings accounts to brokerage accounts. It’s been estimated that 80% of China's urban households invest in stocks, and that equity exposure has increased to at least 30% of their liquid assets, which is a huge increase from the 10% equity exposure level at the beginning of 2014.

The wealth effect in a runaway bull market is clear, the Chinese people have to be feeling poorer in the face of the recent 3-month crash in stocks. At some point this stock market decline will start to impact retail sales.

It will be tough for the Chinese economy to maintain the 10% year over year growth rate that has been its average over the last 5 years. Keep in mind that auto sales, which account for 9% of total retail sales, recently underwent a sharp decline, although that decline was certainly not entirely caused by the decreasing wealth effect.

The second potential impact on the Chinese economy is through a deleveraging of all of the margin financing in China. It's estimated that China has about RMB3.7T in margin financing through brokers' leverage, structured products and equity collateral financing. Equity collateral financing is when companies or big shareholders pledge stock rights to borrow more to invest in the equity market.

The actual size of margin financing is probably even bigger when you take into account all of the “off the books” borrowing that has been diverted into the stock market. These two areas could become very big issues for the Chinese economy, which in turn could cause an economic slowdown throughout the globe.

 

The Bottom Line

Ultimately, the greatest teacher for Chinese officials is to experience a stock market crash. It would teach them that even a completely autonomous and communist government is not capable of defying market forces and human nature.

You can’t have a boom without a bust.

The Chinese government's actions to interrupt the equity market's decline will come at a medium- and long-term price.

First, China's reform agenda and commitment are being called into question because of the government's policy response.
Second, it may make the A-shares inclusion in MSCI global indices less likely than many perceived to have been the case previously.
Third, investors will have to anticipate overhead supply as stability in the markets will be met with the resumption of IPOs and sales by institutions. The problem is that rather than let the stock market return to reasonable valuation measures, China's officials may be creating the conditions for an even larger bubble.

 

Days to Come

China releases a number of critical data points in the coming days.  The key takeaway is that while lending (new loans) remains strong, and the stock market was rallying for most of Q2, the economy continues to slow.

Even though the quarter ended only two weeks ago, the official estimate of Q2 GDP will be announced on Tuesday. The consensus estimate is for 6.8% growth, which would be the envy of most countries, but the weakest Chinese growth since 2009.

The bearish price action and the deteriorating fundamentals continue to remain aligned and warrant a SHORT bias for Chinese equity markets until some of these fundamental market issues resolve themselves.

And beyond the short-term effects, this is an object lesson for investors about how powerful sentiment can be when investing.