“Confine yourself to the present.”
-Marcus Aurelius
The Shanghai Composite was up 4.5% overnight. Depending on which media pundit’s point of view you subscribe to, this move either represents a partial rebound, a dead cat bounce or a lower high.
I had never worked as an analyst prior to joining Research Edge. When I joined Keith here early last year and began to participate in the morning meetings, the process of articulating an investment thesis to an audience seemed very exotic to me. Prior to that my investment experience had been confined to managing a portfolio and I was judged solely by the performance of my P&L, not WHY anything in the book went up or down but simply IF it went up or down. There was no report to be filed, no discussion about the catalysts, timing or risks, no degrees of right or wrong; there was only a single number at the end of every period by which I was judged.
Describing the complex, rapidly evolving, highly volatile current situation for Chinese equities is one of the most difficult things I have ever attempted to articulate in writing, let alone to develop a cohesive investment and risk management thesis for. Our process for China to date has been about three things: 1) trying to maintain objectivity, 2) trying to maintain humility and, 3) confining ourselves to the present.
The first point is simple enough: We have learned to say “I don’t know” and try to take nothing for granted. When we discuss China with investors of all types the one question that comes up again and again is: “Don’t they make up much of the data you rely on”? Our response is usually to remind them that no one in this market, not even the leaders at the National Bureau of Statistics, believes that the economic data produced by the Chinese government is accurate enough to be relied on completely. Like sailors with a bad map, we have to navigate by keeping an eye on the horizon and gather as much marginal data from objective sources to test every component of our thesis at every opportunity. Every one of these tiny data points (a report from a Brazilian metals exporter, comments by a Singapore chip producer’s CFO, a speech by a regional bureaucrat in some provincial city you can barely envision on the map) gets thrown into the process to be vetted.
The second point, humility, is similar to the first but more sublime. We strive to hang on to our fear; to avoid overconfidence. Years working as a trader taught me that only a disciplined mind following a process can consistently outperform, but that perversely is the very success of any process and can be its undoing if that investor becomes arrogant. The development of China’s economy as it moves towards growth fed by internal consumption that has seemingly unlimited potential is a narrative that can be intoxicating. During the rapid run up of the Shanghai Composite in the first half of this year it would have been easy for us to become overconfident. Instead, with every passing 5% up move we became more and more obsessed with finding holes in our thesis –until the initial pullback on July 28th, which came as a relief strangely enough since it validated our fears and forced us to retest our process.
The third point may be the most critical. Before I started this job I believed that the role of an analyst was to look across the horizon and attempt to predict change. I now understand that an analyst’s job is ultimately the same as portfolio managers –to look at the horizon and predict change IN THE CONTEXT OF THE PRESENT.  We are witnessing profound changes in the Chinese economy that may well be the largest economic driver of growth for this century, but in the here and now Chinese equities are also trading based on short term credit levels, investor euphoria and flawed reporting methods. To get somewhere on the map, first you need to know where you are, and that is the cornerstone of our process. Analysts and economists who ignore price action and sentiment in favor of pure data may be right in the long run, but the process of successful investing requires risk management for the present.  
In the coming week we will be reporting frequently on China as our thesis continues to evolve with each new data point. We will be trying to articulate this to you in real-time, with our eye on the horizon and our head in the present.
Andrew Barber

EWZ – iShares Brazil President Lula da Silva is the most economically effective of the populist Latin American leaders; on his watch policy makers have kept inflation at bay with a high rate policy and serviced debt –leading to an investment grade credit rating. Brazil has managed its interest rate to promote stimulus. Brazil is a major producer of commodities. We believe the country’s profile matches up well with our reflation call.

XLK – SPDR Technology Tech and Healthcare remain the two sectors most primed for accelerating M&A activity in Q4. Both look great from an intermediate term TREND perspective, but at a price.

EWC – iShares Canada We bought Canada on 8/11. Canada has what THE client (China) needs, namely commodities, which we believe will reflate as the buck burns.   

QQQQ – PowerShares NASDAQ 100 We bought Qs on 8/10 and 8/17 to be long the US market. The index includes companies with better balance sheets that don’t need as much financial leverage.

EWG – iShares Germany Chancellor Merkel has shown leadership in the economic downturn, from a measured stimulus package and budget balance to timely incentives such as the auto rebate program. We believe that Germany’s powerful manufacturing capacity remains a primary structural advantage; factory orders and production as well as business and consumer confidence have seen a steady rise over the last months, while internal demand appears to be improving with the low CPI/interest rate environment bolstering consumer spending. We expect slow but steady economic improvement for Europe’s largest economy, which posted a positive Q2 GDP number.

XLV– SPDR Healthcare Healthcare has lagged the market as investors chase beta.  With consumer confidence down and the reform dialogue turning negative we like the re-entry point here.

CAF – Morgan Stanley China Fund A closed-end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the wave of returning confidence among domestic Chinese investors fed by the stimulus package. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth.

CYB – WisdomTree Dreyfus Chinese Yuan The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP– iShares TIPS The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are currently mispriced and that TIPS are a efficient way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.

GLD – SPDR Gold - Buying back the GLD that we sold higher earlier in June on 6/30. In an equity market that is losing its bullish momentum, we expect the masses to rotate back to Gold.  We also think the glittery metal will benefit in the intermediate term as inflation concerns accelerate into Q4.

DIA  – Diamonds Trust- We shorted the financial geared Dow on 7/10 and 8/3.

EWJ – iShares Japan –We’re short the Japanese equity market via EWJ on 5/20. We view Japan as something of a Ponzi Economy -with a population maintaining very high savings rate whose nest eggs allow the government to borrow at ultra low interest levels in order to execute stimulus programs designed to encourage people to save less. This cycle of internal public debt accumulation (now hovering at close to 200% of GDP) is anchored to a vicious demographic curve that leaves the Japanese economy in the long-term position of a man treading water with a bowling ball in his hands.

SHY – iShares 1-3 Year Treasury Bonds – If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yields are going to continue to make higher-highs and higher lows until consensus gets realistic.