China's Art Of Risk Management War

"Can you imagine what I would do if I could do all I can?"
-Sun Tzu
 
Sometimes it is best to use the wisdoms of others to make my point. In the Art of Risk Management War, taking one man’s word for it has serious risk.
 
This morning, take the ancient Chinese military General’s heed of caution seriously. The Chinese government could absolutely devastate a lot of what is holding US bond and equity markets together. They own America’s debt. They are the driver of global demand.
 
No, I am not one of these perpetual China bears who are waiting for their broken clocks to be right on another “crash” that they “called”, irrespective of being squeezed for +130% up moves at a time. There are these two little stubborn critters called TIME and PRICE that I get paid to get right.
 
For the last month I have been on the road warning clients that Chinese economic growth is setting up to slow sequentially in Q1 of 2010. The only confirmation biases in my forecast are real-time, marked-to-market, prices. In China’s Art of Risk Management War, prices don’t lie – people do.
 
On that score, here are some fresh prices to consider this morning:
 
1.      China’s Shanghai Composite closed down another -2.1% overnight, registering its 4th consecutive session of declines

2.      China’s Shanghai Composite broke my immediate term TRADE line of support yesterday – that line = 3252

3.      China’s Shanghai Composite has lost -6.5% since December 7th, and is down -10.3% since August 4th

4.      Hong Kong’s Hang Seng Index was down another -0.8% overnight, and has lost -7.7% since November 16th

5.      The Shanghai Property Index was down -5.4% last night and has lost -26% of its value since the July 2009 peak

6.      Poly Real Estate (China’s 2nd largest property developer) got clocked last night, losing another -7.5%


Altogether, I call these sub components of data “risk factors.” All prices are leading indicators that tell me something. My challenge, every morning, is to delineate what factors are mutually exclusive local market risks, versus those that are correlated, all encompassing, global market risks.
 
So, combined with what I know from a fundamental research perspective, what do the aforementioned risk factors tell me?
 
1.      There is a credit bubble in China

2.      Credit bubbles are perpetuated by debt levered asset price speculation

3.      Asset prices in property speculation eventually pop

4.      Eventually, that popping permeates broader market indices

5.      Local markets figure it out first

6.      Global markets follow the locals

 
In this analysis, it’s important to recognize that he H-shares (Hang Seng) are institutionally traded, whereas the Chinese A-shares (Shanghai Composite) are more individually traded. Follow the puck here folks. The local property share index peaked in July. Then the local A-shares index peaked in August. Then the global, institutionally-traded H-shares didn’t peak until November!
 
All the while (particularly in recent months), the Chinese government has become explicit in its warning global investors of price bubbles. But (big but here), with one caveat – AFTER the locals sold the highs! Can you imagine what these guys would do if they told us what they are doing with their US Treasuries and local Chinese stocks, real time? Watch what your competitor does, not what they say. This is China’s Art of Risk Management War.

So back to the point that I made earlier that the Chinese government could devastate US capital markets. The reality is that they don’t get paid to do that. But they do get paid to pay themselves first.
 
The H-shares in Hong Kong broke their intermediate term TREND line this week. Whenever immediate term TRADE and intermediate term TREND lines break, that’s bad. Sometimes, really bad.
 
I beat myself up for missing the US stock market high that was established on December 14th. I felt shame for a day, then I moved on. The question I am asking myself now is, did I mark my own top?
 
So far, the answer to that is yes. The SP500 is now down -1.6% from its YTD peak. Some other questions for me now are: 1. will the SP500 be the last to get the global risk management memo? And 2. Will US markets lag Hong Kong, which has lagged Shanghai?
 
The SP500 broke my immediate term TRADE line of 1101 yesterday. That was my line of support. Now it’s resistance. The intermediate term TREND line for the SP500 is down at 1068. I’ll be a seller of strength today.
 
Have a great weekend and best of luck out there today,
KM


LONG ETFS
 
VXX – iPath S&P500 Volatility For a TRADE we bought some protection at the market's YTD highs by buying volatility on 12/14.

EWZ – iShares BrazilAs Greece and Dubai were blowing up, we took our Asset Allocation on International Equities to zero.  On 12/8 we started buying back exposure via our favorite country, Brazil, with the etf trading down on the day. We remain bullish on Brazil’s commodity complex and believe the country’s management of its interest rate policy has promoted stimulus.

XLK – SPDR Technology We bought back our position in Tech on 11/20. Rebecca Runkle has an innovation story in Mobility and Team Macro has an M&A story in our Q4 Theme, the “Banker Bonanza”. We’re bullish on XLK on TREND (3 Months or more).

GLD – SPDR Gold We bought back our long standing bullish position on gold on a down day on 9/14 with the threat of US centric stagflation heightening.   

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.

 
SHORT ETFS
 
EWJ – iShares Japan While a sweeping victory for the Democratic Party of Japan has ended over 50 years of rule by the LDP bringing some hope to voters; the new leadership  appears, if anything, to have a less developed recovery plan than their predecessors. 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.

XLI – SPDR Industrials We shorted Industrials again on 11/9 on the up move as the US market made a lower-high.  This is the best way for us to be short the hope of a V-shaped recovery.   

XLY – SPDR Consumer Discretionary We shorted Howard Penney’s view on Consumer Discretionary stocks on 10/30 and 12/2.

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


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