If you’re looking for a simple description of last week’s action, I can think of nothing more eloquent as those famous words spoken by Admiral Akbar as his fleet arrived at the forest moon of Endor, only to discover that the Empire was lying in wait: “It’s a trap”.
The skepticism that greeted China’s latest stimulus package was palpable. For the shorts, it was manner from heaven and another opportunity to stock up. There is a general consensus that global markets will need to form a double bottom as part of the current cleansing process, so any rallies are seen as ideal opportunities to add to short positions (where allowed, and if you can borrow the stock).
What I was particularly amazed about was the amount of short selling of the infrastructure stocks that will be beneficiaries of the China pump-priming exercise. Most of these commodity and infrastructure stocks were bid up heavily, while the amount of short selling of these shares jumped to 10-15% of their turnover last Monday. As the announcement was made on Sunday, I wonder how the short sellers were able to borrow so much stock so quickly (particularly as there is an up-tick rule in force). I can imagine the phone calls from prop desks in Hong Kong and London to (related) asset managers asking to borrow stock of building materials company, CNBM (3323.HK). According to exchange records, the stock is owned by seven fund managers (JP, Mirae, Schroders, Baillie, Atlantis, Morgan and T. Rowe) who own a total of 505 million H shares. That’s equal to 56% of all H shares. Yet, somehow, on Monday, 122 million shares were traded (13% of total shares) of which 4.8 million (4% of all trades) were short sellers. Prior to Monday, shorting of the stock had been very small.
Another bear trap arrived in the form of an interest rate cut in Hong Kong last week. HSBC (the world’s smuggest and most hated bank – refused capital from the UK government and has underperformed HS index by 19% since October 8th) succumbed to the pressure and passed a US interest rate cut on to its Hong Kong customers (its UK customers are still waiting). Local Hong Kong banks followed suit, briefly lifting interest rate sensitive stocks. This was followed by the snapping sound of the bear trap. HSBC could pass on the interest rate relief because the HKMA has been automatically pushing liquidity into the HK$ money markets by keeping its obligation to keep the HK$ within a band of HK$7.85/US$1 (the weak side of the peg) and HK$7.75/US$1. Currently, the peg is on the strong side of the range (how different is that to 1998, when speculators were trying to break the peg on the downside?). As with late-2003 and through 2004, the HKMA’s actions have lowered Hibor to almost zero (overnight is 0.1%). This is heartening for borrowers of Hong Kong dollars that use Hibor as their benchmark, but depositors are left with virtually nothing for their cash. For the HKMA, an interesting development has started up again – banks are paying it for its paper! The last auction of 3 month EFBs was seven times oversubscribed and produced an average tender of -0.1% (in other words, banks were willing to pay the HKMA interest, rather than the other way around). Why? Because of the same issues that are affecting the global banking system, banks do not trust each other. Every time an economist, rating agency, analyst or Treasury official says that there is a deep recession coming, buckle up for the ride, expect more banks to go under, bankers are looking at their counterparty risks and saying: no way, I’m not lending to this bank or that bank – I’d rather pay the HKMA and park my surplus funds with it, rather than lose it all. However, there is another issue. When a bank calculates its capital adequacy ratio, lending money (assets) to a bank is given a 20% risk weighting, but buying government paper is given a zero weighting. This is a big disincentive to lend to other banks – particularly as CARs are under pressure from mark-to-market losses. Also, interbank loans do not qualify as collateral at the central bank’s discount window, while government paper does.
A final explanation for remarkable fact that banks are willing to pay interest to the HKMA for its paper could be due to a lack of understanding of the system. Ignorance and temptation are now being added (together with greed and fear) to the list of human emotions/passions that have fuelled the current turmoil in the world’s financial markets. It has to be pointed out that a lot of the top and senior managers that were running the world’s leading Anglo-Saxon commercial banks during the 2004/06-period are still running the same banks now (Green, Ackermann, Lewis, Dimon etc). And just as the increased level of sophistication of the world’s financial systems baffled these senior managers then, so it is swooping over their heads now. Treasury Secretary Paulson is a good example. As CEO of Goldmans in 2006, he reportedly received US$16 million in wages (less than the US$37 million in 2005). Much of that compensation was derived from sales of the now toxic investments put together and sold by his subordinates. Did he know what his sales teams were selling? Did he foresee that they would turn noxious? No. This is the point. Bank senior management did know what was going on, while the recipients did not know what they were buying. I am sure the Treasurer of ICBC (Asia) is good at his job. But when interest rates were trending to zero in 2004 and barely much better in 2006, he would have been under some pressure to look for higher yielding assets. CDOs, SIVs and bonds issued by Icelandic banks must have looked like the most fantastic dessert trolley in the history of gastronomy. There is no way he could not resist the temptation. The fact that he has had to write-off HK$600 million in Icelandic bond investments is both tragic and symptomatic, of the greed, ignorance, temptation and now fear that is gripping the world’s financial markets. If you are getting tired of hearing this, then maybe that’s a good thing.
As compensation, here are two small pointers that suggest there are signs of fatigue in Hong Kong’s equity market. This could give Admiral Akbar hope that the evil Empire (led by those bad shorts a.k.a. the Darth Vaders of Wall Street) can soon be defeated.
First, the gross open interest on the HS Futures contract has been steadily declining since the November contract started. In fact, among the many records being currently broken, few would have noticed that the record high daily volume for HS Index futures contracts was on October 28 at 244,461, beating the previous high of August by 17%.
Generally, the futures contract has been the most efficient way to short Hong Kong shares in recent months (because it’s cheap). There can be two explanations for the decline 1) traders see the end in sight or 2) banks are pulling margin financing. The open interest shouldn’t be lower because: HK$ financing costs have been falling and the news-flow has been significantly on the negative side in recent weeks.
The second sign of fatigue is the decline in short selling of individual stocks. The percentage of short selling to total turnover has been steadily declining in recent weeks, while the correlation with the index’s daily-points change has been decidedly negative at -0.45. Explanations for the decline in short interest range from: traders see the bottom (again) or there’s no more stock to lend.
Although I have sympathy with short sellers (they are buyers at the bottom of markets, they are great investigators etc), but they have a problem with the morality of shorting a stock and effectively attempting to drive the stock price to zero (the maximum benefit). Buyers of stock are not attempting/hoping to bankrupt a company, shorts, by implication, are. Then there’s the issue of accuracy. What if you’re wrong (short sellers get it wrong most of the time, just as long investors do) – you could drive a perfectly good company to the ground, resulting in lost jobs, and a domino effect leading to a mass panic. The markets are currently regulated in your favour, with credit rating agencies downgrading their view of a credit based on the stock’s price performance. Also, only a certain few can short sell, because you need to borrow the stock, usually in large amounts from an institutional shareholder. By doing so, that lender will be aware of your actions. This is not equitable disclosure.
There is no sign of fatigue in the world’s forex markets. In fact, the unraveling of the yen carry trade actually accelerated last week. It has been this unraveling that pressured equity prices lower last week (neither Paulson’s U-turn nor weak economic/corporate data paled in comparison), and it will continue to dominate trade this week. Expect talk of yen intervention and a talking down of the volatility of US$. In the meantime, the 20-day moving average has become something of a barrier for the index (it popped above it on November 5 and 10, only to fail to hold it), suggesting that selling pressure will occur around 13,900. The downside is the previous low of 11,000.
