Bear in a China Shop

by Victor Sperandeo with the Curmudgeon

Note: This is the 2^nd of a two part Curmudgeon series on China's stock markets. The opinions in this article are those of Victor Sperandeo. Stronger opinions are expressed in italics. You are not likely to find these explanations for China's up and down market moves anywhere else!

The 1^st article, written by the Curmudgeon, can be accessed here.

Questions to Ponder:

1. Why have China's stock markets crashed?

2. More importantly, why did they go up in the first place?

Let's examine these questions in reverse order.

China's benchmark "Shanghai Composite Index" advanced from 1846.65 on 6/25/13 to 5178.19 on 6/12/15 or an advance of 180% in 717 days. From that high, it then dropped to 3507.19 on 7/8/15. That's a decline of ~ 32.27% in only 26 days.

Caption: Bear Defeats Bull in China's Stock Market

The extent and short duration of China's stock market decline is mostly due to the retail Chinese “investor” getting into this (capitalist system) “easy money” game late, and using maximum amounts of leverage (often 5 times equity) to own stocks. In addition, the Chinese are the ultimate momentum players.

[A true story from a Macau China casino is that on a roulette wheel "Black" came up 12 times in a row.... everyone bet black for roll 13?]

China's UP MOVE explained:

Why the big up move in China stocks when GDP was declining? China GDP grew +7.9% for 2012, 7.9% as of 9/30/13, then declined to 7.3% as of 9/30/14 and further to 7.0% on 6/30/15. 6.8% is predicted at the end of year by the IMF and Nomura Securities agrees.

China stocks moved up for a very good, but subtle reason that was known to some, but not really understood by most.

China was applying for Reserve Currency status with the IMF, as explained in an April 1, 2015 WSJ article titled: "Momentum Builds to Label Chinese Yuan a Reserve Currency.”

“The amount of China’s trade that was paid for in yuan, for example, has risen from 0.02% in 2009 to nearly 25% last year, according to the Hong Kong Commissioner’s office.”

Many believed that yuan reserve currency move would help accelerate the liberalization of China’s long-closed financial markets and hence attract lots of foreign institutional investors. Joining the dollar, euro, pound and yen in the IMF’s reserve-currency basket could lead to $1 trillion of inflows into yuan assets, BlackRock Inc. estimated. But there's much more to the story than that!

Currently, the MSCI All Country Index has a zero allocation to China bonds and only 1.7% allocation to China stocks. That's less than Spain, despite China being the 2^nd largest economy in the world!

If China gets a 10% allocation of to global stock market ADR's, the index buyers worldwide will have to purchase a huge allocation of China stocks and bonds. The Index buyer outside China, whose job is not to guess or speculate, are the future buyers of Chinese stocks, if and only if the IMF approves China reserve-currency allocation.

Further clues to China's intentions were reported in an article titled: "China’s Yuan Could Get IMF Reserve Status This Year.”

"If the International Monetary Fund endorses China’s yuan as a reserve currency this year, it could see at least $1 trillion worth of its reserve switch into Chinese assets, according to Standard Chartered Plc and AXA Investment Managers. Officials at the Peoples Bank of China have called for the IMF to include the currency in their reserves later this year when it hold its review. The reserves basket is currently made up of the dollar, euro, pound and yen.”

An estimate from Bank of America Merrill Lynch in March suggested that the yuan could get a potential weighting of 13% of the reserves basket, while HSBC Holdings Plc said last month that China’s importance in global exports could send the weighting as high as 14%.

“SDR (Special Drawing Rights) inclusion in 2015 would likely have a significant market impact, driving an immediate sharp increase in global diversification into renminbi assets,” Standard Charter's Liu and Cheung wrote. “It could trigger a reallocation of global reserves portfolios.”

Think about what would happen if 10% of Chinese ADR stocks were added to the S&P 500 index? That's much more important to China stock markets than GDP growth (or declines). Speculators anticipating these asset shifts is the likely reason that CHINA STOCKS WERE INCREASING 90% per YEAR on average (compounding at 67.3%), while China GDP was declining!

China's DOWN MOVE Decoded:

So much for the hidden story behind the up move. Why are China stocks crashing? There seem to be two reasons, which when taken together negate the notion of any increase in yuan SDR/ADR allocation (as explained above).

China's Hacking U.S. government workers. A June 4^th Washington Post article stated that 4 million federal government workers were hacked by China. On June 23rd that number was bumped up to 18 million workers and on July 9th revised up yet again to 22+ million hack victims!

This is very serious indeed, as it can lead to blackmail and limitless secrets that can be used for illicit purposes that harm national security. It is undoubtedly an embarrassment for the Obama administration.

China's artificial “Island Building” in international waters. A CNN article asks "Should U.S. worry about China's island building binge?” We say yes!

This is a very challenging situation in our view. It makes the U.S. look weak and can cause a war as these are free waters and not considered part of China by virtually anyone.

In my opinion, the above two early June events have probably caused the U.S. to put extreme pressure on the IMF to NOT permit a change of status in China's Yuan ADR/SDR currency allocation. When the U.S. started to pressure the IMF due to the Hack, the word got out to retail “investors” and the late buyers were forced to sell stocks and take big losses.

As evidence that this is occurring it must be asked why U.S. government bonds spiked over 2 full points from a low on June 11th when China topped on June 12^th. So bonds made a low, and China a high at the same time for no known reason?

Conclusions:

1. China's boom/bust example is really a crystal ball view into the psychology of “investors’ around the world today. It’s likely depicting what will happen to the S&P 500 in the future. The only question is when?

2. If China does not get the increased reserve currency/ADR gift from the IMF, the payback for their U.S. hack attack and their island building will be very expensive indeed. Why payback? Let's turn to Samuel Johnson, the famous 18^th century English writer:

"Revenge is an act of passion; vengeance of justice. Injuries are revenged; crimes are avenged”

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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