Conclusion: Losers point fingers; winners learn from their mistakes.
Yesterday, we decided to close the books on one of our key themes YTD: Year of the Chinese Bull (2Q)/Chinese Cowboys (3Q), booking an -8.6% “loss” vs. our cost basis the Hedgeye Virtual Portfolio. Rather than blame “speculators”, Europe’s Sovereign Debt Dichotomy, or some other consensus go-to scapegoat, we thought we’d take the opportunity afforded to us in loss to demonstrate how we’re always trying to improve our ever-evolving risk management process:
What Went Wrong: From a research perspective, not much really. The key components of our call (no “hard landing”; CPI peaking in 3Q; and no more monetary tightening in 2H11) largely came in as we anticipated. In hindsight, if there’s something we chose to ignore that we shouldn’t have, it’s the sheer magnitude of the issues the Chinese banking system is set to face.
We’re fully aware of China’s property market headwinds and the pending deterioration of credit quality within local government financing vehicle debt (refer to our spate of research notes on these subjects over the past year(s)). What we misjudged perhaps was how bad things truly were, as well as how close in duration these catalysts would become. Specifically, according to a study published today by the country’s official bond clearing house, 28% of local government financing vehicles (6,576 in total) now have negative cash flow from operations, which obviously makes it difficult to stay current with their debt obligations. Additionally, roughly 22% of these entities have debt-to-asset ratios greater than 70%, which means they’ll likely face difficulty securing refinancing – certainly at higher rates, if at all. Lastly, the PBOC’s monetary tightening was largely the “straw that broke the camel’s back” as it relates to creating liquidity headwinds for this segment of the Chinese economy – which itself is levered to fixed asset investment at nearly half of all GDP growth.
What We Learned: We re-learned that consensus can remain correct a lot longer than one expects. It’s in our competitive nature to be contrarian as risk managers, but, as always, there’s a fine line between being contrarian and being too early/wrong. Recall that we initially authored our bearish view of Chinese equities back at the start of 2010 via our then-contrarian Chinese Ox in a Box theme. Fading that view, which had since played out in spades in market prices, economic data, and in financial media coverage, was one of the reasons we decided to get long Chinese equities earlier in the year. Bottoms are processes – not points.
What We’ll Do Better Next Time: It’s safe to say that we need to have our catalysts much closer in duration – particularly given the negative beta imposed on equities as an asset class globally in the YTD. When the quantitative setup of an asset class (in this case, Chinese equities) is bearish TREND or bearish TAIL, we’d do better to have our bullish catalysts much closer in duration vs. when the quantitative setup is bullish TREND or bullish TAIL – a setup that allows for extending the duration of said storytelling.
Chinese equities, which had not sustainably broken out above their TREND line at any point in this process, were telling us all along that things weren’t “ok” in China. That’s not to say our quantitative model is 100% accurate all the time; it is, however, suggesting that it has repeatedly served us quite well over the past 3+ years in making a bevy of accurate calls across asset classes. In terms of risk management, we’re no doubt at our best when we’re able to marry our bottom-up, fundamental research view with our top-down, quantitative analysis:
All told, we’re not happy about being wrong on China here. We are, however, not going to dwell on the loss or allow ourselves to succumb to thesis drift and pitch “valuation” like your average sell-side strategist would. There’s a lot more risk to manage in the weeks and months ahead.