Goodbye China

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:


Goodbye China - 1


Goodbye China - 2


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.


Darius Dale


Cartoon of the Day: Bulls Leading the People

Investors rejoiced as centrist Emmanuel Macron edged out far-right Marine Le Pen in France's election day voting. European equities were up as much as 4.7% on the news.

read more

McCullough: ‘This Crazy Stat Drives Stock Market Bears Nuts’

If you’re short the stock market today, and your boss asks why is the Nasdaq at an all-time high, here’s the only honest answer: So far, Nasdaq company earnings are up 46% year-over-year.

read more

Who's Right? The Stock Market or the Bond Market?

"As I see it, bonds look like they have further to fall, while stocks look tenuous at these levels," writes Peter Atwater, founder of Financial Insyghts.

read more

Poll of the Day: If You Could Have Lunch with One Fed Chair...

What do you think? Cast your vote. Let us know.

read more

Are Millennials Actually Lazy, Narcissists? An Interview with Neil Howe (Part 2)

An interview with Neil Howe on why Boomers and Xers get it all wrong.

read more

6 Charts: The French Election, Nasdaq All-Time Highs & An Earnings Scorecard

We've been telling investors for some time that global growth is picking up, get long stocks.

read more

Another French Revolution?

"Don't be complacent," writes Hedgeye Managing Director Neil Howe. "Tectonic shifts are underway in France. Is there the prospect of the new Sixth Republic? C'est vraiment possible."

read more

Cartoon of the Day: The Trend is Your Friend

"All of the key trending macro data suggests the U.S. economy is accelerating," Hedgeye CEO Keith McCullough says.

read more

A Sneak Peek At Hedgeye's 2017 GDP Estimates

Here's an inside look at our GDP estimates versus Wall Street consensus.

read more

Cartoon of the Day: Green Thumb

So far, 64 of 498 companies in the S&P 500 have reported aggregate sales and earnings growth of 6.1% and 16.8% respectively.

read more

Europe's Battles Against Apple, Google, Innovation & Jobs

"“I am very concerned the E.U. maintains a battle against the American giants while doing everything possible to sustain so-called national champions," writes economist Daniel Lacalle. "Attacking innovation doesn’t create jobs.”

read more

An Open Letter to Pandora Management...

"Please stop leaking information to the press," writes Hedgeye Internet & Media analyst Hesham Shaaban. "You are getting in your own way, and blowing up your shareholders in the process."

read more