Sneaking One Past the Goalie – CAF Trade Update

Position: Long Chinese equities (CAF)

Late yesterday afternoon, Keith purchased the Morgan Stanley China A-Share Fund (CAF) in our Virtual Portfolio. Not for the faint of heart, Chinese equities closed 2011 down -21.7% after front-running 2011’s global growth slowdown by falling -14.3% in 2010. Cumulatively, the Shanghai Composite Index is down -31.8% and China’s yield curve (10’s-2’s) has compressed -82bps since we made a then-contrarian bearish call on China in Jan ’10 via our Chinese Ox in the Box thesis. For comparison, the S&P 500 is up +11.1% over that same duration.

That’s certainly not to say we’ve had it right the entire time. We were bullish on China from a fundamental perspective throughout the second and third quarters of 2011, based largely upon a series of internal and external catalysts that included: 

  1. A slowing of the multi-year deceleration in rates of Chinese economic growth;
  2. A peaking and a subsequent rolling over of Chinese inflation;
  3. An introduction of accommodative monetary policy – first via ending the tightening cycle and secondly via introducing an easing cycle; and
  4. Slowing global growth forcing investors to pay a premium for the growth they could find (i.e. China). 

For the most part, this thesis is still very much intact and could come to fruition in 2012. What made us early (and wrong) was the misjudgment of Time & Space Risk, or the amount of trading days it would take for the catalysts to line up and valuation to become supportive enough to warrant a purchase of Chinese equities to the marginal investor.

In full respect of the coaching points learned from the last rep, this is certainly not a risk we’re likely to miscalculate again – particularly given current elevated levels of volatility across asset classes (i.e. time itself is a major risk factor when volatility is high). That said, however, we did see a near-term opportunity for a short-term mean reversion trade in Chinese equities. Our process was rewarded with a +1.2% bounce in the Shanghai Composite Index overnight on the strength of a sequential acceleration in HSBC’s Manufacturing PMI report (48.7 DEC vs. 47.7 NOV).

More importantly, the gain fueled the index to a close just above our TRADE line of 2,190. We’re still long and we’re happy to wait and watch to see if this confirms. The next line of resistance (TREND) is up at 2,381. A sustained breakout above the TREND line would likely put the aforementioned storytelling back in play and may force investors to chase China. And while this is an outcome we do not necessarily expect at the current juncture due to the sheer uncertainty around the magnitude of the growth slowdown and the associated implications for the banking and property sectors, we are cognizant of the fact that every trend starts with a mere trade

Wishing you all the best in the New Year,

Darius Dale

Senior Analyst

Sneaking One Past the Goalie – CAF Trade Update - 1