#1 Investment Weekly – Cynics everywhere

Oscar Wilde described a cynic as a person that knows the price of everything and the value of nothing. He probably wasn’t thinking about stock market investors, but his insight seems to have encapsulated the current reality of global equity markets. There seem to be cynics everywhere right now. Basically, these are investors who did not believe the solidity of the March lows and are trying to understand why they should believe equity values now, despite the surge in prices around the world.

It has been a golden week for cynical conduct, started in Hong Kong by investment bankers from Morgan Stanley that dumped their cornerstone investment in Shanshui Cement a year after bringing the stock to market, followed by the G20 photo-op and capped most handsomely by the spin doctors at HSBC who, on announcing that their CEO would be relocating back to Hong Kong so as to oversee the bank’s expansion in the region, cynically forgot to mention that those shareholder terrorists Knight Vinke had been pressuring the bank to cement its Asian credentials by making a move like this for years.

With this sort of cynical behaviour going on locally and around the world, it was little wonder that the Hang Seng Index gave up its previous week’s gains. Global equity markets are starting to look a little jaded, with the amount of new stock coming to market, overwhelming demand. The Morgan Stanley sale struck right at a time of high IPO issuance, leaving IPO investors fearful that so called cornerstone investors will dump stock as soon as no one is looking. This explains why IPOs last week performed poorly. The G20 meeting was as useful as a cut in US dollar interest rates, with officials appearing to talk up the US dollar’s price while at the same time admitting that its value was diminishing as the reserve currency of choice. HSBC’s announcement that its CEO will move to Hong Kong was the most cynical piece of knee-bending you will ever get to see. There are many instances of overseas companies bowing to the wishes of China and its huge potential for profits, but coming from a company that started its life in the colonial years of Shanghai and Hong Kong was a slightly pathetic sight to see.

On a final note of cynicism, I was sad to read that that great bastion of Empire, the Far Eastern Economic Review, is finally set to close in December. The regional weekly magazine had been publishing well-written, hard-hitting articles about topics of great importance for the region for many decades. That is, until 2001, when Dow Jones decided sack its staff and changed the editorial direction. Actually, the start of the slippery slope was in 1987 when HSBC sold to Dow Jones, so the writing has been on the wall for quite a while. My sadness at FEER’s demise stems from my time as the chief editor of a competitor regional banking magazine in the late 1980s. Our advertising sales would ritually put down FEER despite the fact that our publisher was an ex-FEER man and our correspondents contributed to FEER. To be honest, we were mostly in awe of the magazine, and actually FEERed it. Its demise is not surprising, of course, because, we sold out to a giant Australian publisher, only for the magazine to close down a few years later. Editorial direction was changed, the culture of the magazine was cast aside, and the content’s integrity was irreversibly lost. Twenty years later the same mistakes were made by Dow Jones, with the same result. However, all is not lost: if you wish to read articles by noted journalists on topics related to Asian business or politics – simply search the net and read for free.

So, if you want cynical-free advice on the direction of the Hang Seng Index for the shortened week ahead, here it is, from an independently-minded, ex-banking magazine editor: it will move sideways to lower in thin turnover. I believe the first signs of uncertainty about the bull market are starting to appear as valuations (not prices) are now close to pre-Lehman levels. The first phase of the usual three stages of any bull market in equities is coming to a close. The easy money has been made. The next phase will require discovery, investigation and an increase in risk. While the transition phase to the next part of the cycle pans out, money will move to the sidelines. Traders will take their profits and wait for dips down to the bottom of the Bollinger Band at 19,400, while long term investors should not concern themselves with movements within the current upchannel, as long as the long-term support line doesn’t break the neckline at 17,000.

#1 Investment Weekly – A global peg?

Hong Kong’s leaders are constantly harping on about how they want the SAR to be a global financial centre. Unfortunately, this dream can never be fulfilled while its currency remains detached from the rest of the world and limited in scope as it is. A point in case is the overstated impact that mainland IPOs have on the Hong Kong dollar.

Hong Kong’s peg to the US dollar is getting plenty of air time recently (alongside Panama’s much older US$ peg) as the debate about establishing a global reserve currency has grabbed the attention of right-wing economists (Stiglitz, Roubini et al) and politicians (principally the US and China). From the economists’ point of view a global reserve currency has plenty of positives in terms of helping to rebalance trade surpluses and deficits, while providing greater stability to the world’s financial systems – something that was lacking during the meltdown of 2008. Politicians are grabbing the opportunity to play the global reserve currency card in their efforts to appease their voters. On the one side, the US insist that the US dollar did not exaggerate the problems of 2008, while China (who has the most to lose from a weak US$) and a few other neutrals such as Russia are pushing for a debate about the idea of a more stable currency regime. The IMF, the possible arbiter of any such arrangements, is encouraging all sides to discuss this, as this increasingly marginalized organization attempts to secure its future.

Disbelievers of the possibility of a new global currency regime are probably those that believed the Euro could never happen, or that the Euro will not be able to withstand the current slowdown in economic activity in the Eurozone. Fortunately, the sceptics may not be around long enough to see the establishment of a global currency reserve (it took 20 years for the Euro to arrive), so we may never to able to tell them they were wrong. But, just as it is almost certain that one day the Renminbi (or its equivalent) will be the currency of Hong Kong, so, investors should be prepared to admit to the inevitable that a more stable economic future lies in the establishment of a more solid currency regime relative to the current set up.

However, this is a long term inevitability, and one that will require much political will, and further tweaking of the experiences that Hong Kong has had to initiate in the 26 years since the establishment of the HK$’s peg to the US$. For one thing, a method of relieving pressure on a pegged exchange rate system when there are sudden and large movements of demand in a particular country or system.

The chart below is the nominal amount of HK$ money supply. The shape of the chart is not particularly unusual in that there is a general movement higher throughout the time period. Hong Kong’s economy has prospered on the back of China’s success.

HK$ M3 (HK$ billion)

However, what is of real interest here are the large amount of outlier months during the period. If you look at the chart, you can probably make out at least 10 occasions when HK$’s M3 shot up significantly in a particular month, only for the stock of money to revert back again a month or two later. Generally speaking, these spikes coincided with large IPO offerings (or, on one or two occasions that I can remember, when large HK$ loans were drawn down). The data is only for the month end, so, there are a large number of IPOs that did not straddle the month end and therefore are not included in the data. If they were included, the chart would look more like a saw blade, with patches of blunt edges.

During these spikes in demand for HK$, Hibor interest rates would have fallen well below there natural levels, thus giving the impression to outsiders, particularly those quant funds that may not have been aware of the reason for the short term decline in rates, the impression that something is happening that may be worth trading on.

If enough fund managers pile in, the situation could be destabilizing, particularly as interest rate begin to normalize after the IPO is complete. This is what happened during the Asian Financial Crisis in 1997. Although Asian currencies were being devalued around the region, the HK$, which was pegged to the US$ was unchanged. The quants saw this was an opportunity to attack. They used HS Index futures contracts to short stocks and attacked sold the currency. In the meantime, Hong Kong listings of IPOs were continuing to lift the money supply well after the baht devalued. When the IPOs ceased, and the crisis worsened, the M3 fell back, only to surge again after the HKMA’s August stock market intervention. An almost perfect rerun of 1997, occurred again in 2007, as huge IPOs flooded the Hong Kong stock market (encouraged by the “through-train” idea), thus exaggerating the money supply. The pull back in M3 in 2008 was partly due to foreign banks pulling down their liquidity, but also because the IPO proceeds were being repatriated back to China.

One lesson from the Hong Kong experience then is that there can be no outliers in any future global reserve currency regime. Particularly if the currency is small relative to the size of its capital markets (Pound Sterling springs immediately to mind). The Hong Kong dollar could not stand alone under such an environment as China’s currency certainly be included in the reserve currency regime. If China and the US give up the national rights of their currencies, I’m sure Hong Kong (which is ostensibly pegged to both currencies) would be forced to follow.

This is probably a long way off, nearer in time is the likelihood that China may have to start seriously thinking about cooling its asset markets. SHK Properties has just announced record high offers for flats at its Cullinan development. Hong Kong is now officially out of recession, and the streets, restaurants and shops are feeling a little bit too packed for comfort. Equity prices are feeling decidedly toppy, with retail punters rushing at every new tip and IPO. If the world’s leaders are serious about avoiding the errors of the past two years, a short sharp reminder that nothing goes up in a straight line, and that investors are supposed to invest in the stocks of companies, rather than consider the stockmarket as some form of gambling/ATM machine, then a few choice cooling words from either side of the Pacific would be appropriate at this time.

Technically the HS Index continues to bump against the top of its trading range. Although turnover picked up towards the end of last week, part of this was due to the half day of orders lost on Tuesday because of a typhoon, while volume was not unusually heavy. In fact, average turnover and volume fell compared with the prior week. A put:call ratio of over 90% and rising short selling suggest a period of calm, price weakness ahead of the Golden Week holiday in China and holidays in Japan as well as the disruptive impact of IPOs in Hong Kong and the US.

#1 Investment Weekly – Harmony and stability

I’m not sure how seriously the market took the news that China’s main financial regulator (SASAC) had issued a guidance note stating that it would be acceptable for mainland banks/state enterprises to default on certain commodity derivative contracts because they were not transparent enough. It is the type of defiant proclamation that seeps out of China on a regular basis, and so, it seems to have been ignored – as the others generally are. However, this may be one of those rare occasions when ignoring China’s hubris could be dangerous.

“An harmonious and stable crackdown” is how The Economist has described the past 60 years of Communist rule in China – which will be vehemently celebrated (by China’s leaders at least) at the end of the month. I suspect that the cadres in Beijing will also be keen to show the world that while the country has embraced the vagaries of the free-market for more than half the time of the Party’s existence, this has always been done with Chinese-characteristics (which is a moniker for: balancing yin and yang and doing things for the long run). With this is mind, I would not be surprised to find that another Mainland trait, which has often been employed over the past 30 years, and that is the element of surprise (one of Tsun Tsu’s many pieces of useful advice).

Combining centrist control and free-wheeling market forces is a delicate balancing act, and, right now, the free markets are riding rough shod over the controlled expansion of China’s economy. An element of control is required, and the SASAC announcement sounds like something that the Chinese could employ to put a check to the unfettered upsurge in China’s asset prices. For one thing, the market has seemingly ignored the threat that walking away from contracts will have on the world’s financial markets. The last time China turned its back on binding contracts was during the ITIC crisis of 1998-99, when local and international banks were forced to write off billions of dollars of loans that they had assumed were guaranteed or backed by the Chinese government. It turned out the contracts were worthless. In other words, China has history on this sort of threat, while at the same time the authorities are trying to bring about a harmonious and stable crackdown on the country’s booming asset markets.

The negative news from China’s controllers was increased a notch further – very late last Friday- by the threat of a trade war with the US: this time over tyres. I suspect that the market will be hearing more and more of these sorts of superficial stories as the Shanghai index attempts to return back to its previous high of 3,400. The list of possible negative newsflow could include: higher stamp taxes (stock market or on property), a serious clamp-down on loan usage or a tightening of bank reserve requirements. However, these are more like last-resort moves. There may be other types of stories before the big hitting brakes are applied.

With these sorts of threats hanging over the market, a pull back from current levels would be a natural course of action to take. The index is already pushing on the string which represents the top of its Bollinger Band, and, therefore, needs to take a breather. Turnover will drop because of the uncertainty of what sort of threats may come out of China, but also because funds are being raised by a large amount of IPOs coming to the China markets (10 deals raising US$7.14 billion in September alone).

Even if there is a self-induced pull back in the HS Index to the bottom of the Bollinger Band, at 19,400, or maybe even to the bottom of the Ichimoko Cloud at 19,100, the medium term uptrend from the March low will still be intact. So, any weakness from current (slightly over-extended) levels can be viewed as a buying opportunity, rather than a major threat to the current bull market.

#1 Investment Weekly – Can’t beat squiffy Beidaihe

Most investors know the saying “Don’t fight the Fed”, but we in Asia have a more potent catchphrase: “Can’t beat Beidaihe”. It’s a well known fact here that China’s political leaders head to the nearest summer beach resort to Beijing to cool down and plot the country’s future. There’s another saying, which is slightly less known, which uses the word squiffy to describe how China’s leaders, even when slightly tipsy while on their holidays, can still tweak equity markets. It’s basically a word play on the ubiquitous QFII.

Information about short selling of Hong Kong shares is limited to deals done through the exchange. Over the counter deals, which are significantly greater that anything seen through the exchange, are hidden from view. However, although the data is limited, the chart probably gives a good idea about the direction of flows. In recent sessions, the direction had been sharply higher – although a peak daily short sale of HK$6 billion is only a tenth of a typical day’s trade.
Hong Kong short trades as a percentage of total turnover (%)

The interesting point about the short squeeze last Friday was how quick it all unraveled. Ahead of a long weekend in the US and a volatile jobs report, Beijing announced a minor adjustment in its SQIFFI rules which literally blew the short sellers out of the water. However, there is something of a mystery about why the shorts got burned so badly. Although the chart shows a gradual build up in short positions in recent weeks, most of the short-selling had been concentrated on the A50Tracker (an A share ETF listed in Hong Kong). The fund only tracks A shares, not Hong Kong stocks. This explains why the A50’s correlation with the Shanghai Composite is much tighter (about 10 points) than its fit with the HS Index. The shorts should not have been holding a lot of short positions in individual Hong Kong stocks if they believed that the return of the correlation between the A50 and Shanghai was the trade.
Correlation between HS index/A50Tracker/Shanghai Composite

The relationship between the A50 and the Shanghai Composite started breaking down in recent weeks, with the Shanghai market correcting 20% in August. The shorts piled into the A50 trade assuming that the A50 proxy would follow Shanghai below its support line. It did, but this came to the attention of the mandarins in Beidaihe. Shanghai’s 5% recovery-bounce on Thursday got the shorts worried. They started to unravel their positions in the A50, and let go of the rest when they heard the low estimates for the US payroll number. They finally got nailed by the squiffy news.

What should the shorts have learned after their latest little escapade? Some of this will sound familiar and obvious, but sometimes reminders are necessary. First, and this is a recurrent theme of China’s equity markets, when looking at China, you need to understand the whole political picture. News of fresh unrest in the west of the country needed to be counteracted. At the same time, a sharp decline in equity prices was threatening to upset the affluent west coast. Although the drop in equity prices was needed, it was entirely self induced and therefore entirely fixable. The bank regulator had noted a huge increase in share margin financing, and applied the breaks. The solution was easy, send in the troops to the west (and block media coverage, of course) and issue quotes from senior cadres pointing out that slowing loan growth will not hamper economic development – oh, and, on a Friday afternoon, announce an increase in QFII quotas just for good measure. The shorts underestimated China’s control of its markets, and suffered. Second, China is a developing market, which means greater risks, but also greater returns compared with more mature markets. The 20% decline in Shanghai in August is symptomatic of the risk one takes in a market that can run up 30-40% in the blink of an eye. You can win big, and lose big. Third, no matter which way you look at it, we are in a bull market, and it won’t peak/finish until the index has expanded its earnings multiple to over 20x. Finally, short sellers should always watch currencies for signs of stress. The most important for the A50 traders was the strength of the HK$ relative to the US$. The HKMA had to intervene to keep the peg rising above the HKMA’s Convertibility Undertaking last week. This meant that despite the big build in shorts, investment dollars remained in HK$. The dip turnover as the market fell was another key indicator. The sellers weren’t dumping stock as hard as the shorts had probably hoped.
HS Index price/turnover (HK$b) August/September

Obviously, the bears will continue their attacks, and this will cause periods of weakness and uncertainty during the rest of the upcycle. Weak buyers will panic sell, while long term investors with holding power will scoop up on the dips. The current market’s conditions are quite positive in the near term as the index bounces off the bottom of its Bollinger band (confirmed after the index closed about the 20-day moving average last week). The near term top is just over 21,000, and that barrier will need to be tested another two more times, as the price/turnover chart suggests some gap filling in required, before a new leg up in the cycle can begin.