#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.

#1 Investment Weekly – Interference

There has been a lot of talk about how Government intervention has helped prop up economic activity recently. Stimulus packages may be the devil incarnate according to History buff, Niall Ferguson, with dire, long-term, consequences for budget deficits, but short term traders are not interested. Paul Krugman believes stimulus is a necessary evil if we are to get the world’s economies moving again. The mandarins in Beijing agree with the latter view, but only on the premise that once in a while, horns need to be reined in – just as they are doing so now.

The problem with the Ferguson/Krugman argument is that both live in that iron-rice bowl known as tenure and in the great big goldfish bowl of academia. Neither have any credibility – but its been fun to watch this Trans-Atlantic brain tussle. While both are right that piling on debt is only going to lead to trouble in the long term and the market should decide, while stimulus packages/rescues were necessary and big government is important right now, China’s leaders are probably looking on wondering what all the fuss is about. Beijing started the stimulus well before anyone else, allowing the Shanghai Composite to rally from its low well before the rest of the world officially called the end of the bear market. So, it is appropriate that China, who can now lay claim to being the foremost authority on such matters, is the first to tweak the faucet.

I am sure that Beijing is watching the medium term uptrends of both Hong Kong and Shanghai very carefully, making sure that neither index falls below their trend lines. They are not want to undo all their good work turning around confidence in equities. So, I see buying opportunities in Shanghai (if you can get hold of A shares), while Hong Kong has more downside, but the buck must stop at 19,000 to avoid some sharp technical selling. To ensure that this does not happen, I’m sure that Beijing’s mandarins have had a quick peek at some of the first half earnings numbers and are betting that they should be sufficiently encouraging to keep the bulls happy, and give those nasties that were piling on the puts last week back in their rightful place. While that scenario plays out, the index is likely to swing around in a narrow band.

I’m sure, as well, that the authorities are aware that the shortest bull market’s in Hong Kong’s recent history both lasted 11 months and that a halt to the recent recovery now would set a major precedent. In fact, just to match a normal bull market return, the index has to reach about 30,000 by May next year (I’m assuming that we don’t have a 911 type market because it’s impossible to predict such events).
HS Index bull-bear phases

In other words, there is still another 50% before we reach a normalized return. Finally, everyone knows that Hong Kong bull market cycles always end with a PE multiple of +20x. Therefore, the conditions are not ripe for an end to the current bull cycle, and the upcoming results season, plus the occasional piece of Government-inspired good news should keep both markets afloat.

The earnings season in Hong Kong has just begun with those China-focused bankers at Bank of East Asia, as always, laying themselves open to scrutiny first. The HK$384 million or 48% increase in first half net profit looked impressive. However, there was a positive HK$1.4 billion swing in investment profits which meant there was HK$1 billion which didn’t show up on the bottom line. The breakdown of the disappearing profits was evenly split between: lower net interest income, higher operating expenses and higher provisions. Interestingly, there was no change in impairments to China customers, but a 47% jump in Hong Kong customer delinquency. The real killer was a 300% surge in overseas delinquencies (is this why it sold its Canadian banking business to ICBC?) We shall never know. The stock has underperformed the HS Index by 10% since the beginning of June, and these results are not likely to manipulate that trend much.

You’ll be glad to hear that Hong Kong’s stock market regulator is finally putting those end-of-day auction-manipulators out on the streets. They aren’t being thrown in jail, but rather the SFC has suspended their prison sentences or their licences. Bank of China’s shares seemed to be a common target for the two known cases (a private investor and a broker from Corporate Brokers) which both took place a year ago. Fortunately, the suspensions should put an end to any prospects of re-introducing day-end auctions. We can’t have amateurs illegally manipulating equity prices, when we have a Keynesian behemoth up north doing it Krugman-style for us.

#1 Investment Weekly – What recession/bear market

The whole financial world has gone mad. Apparently, while I was away on my usual summer holidays, a big part of the European economy pulled out of recession and China’s stock market entered a bear market. Although the first statement could be technically correct, the audience has no idea what it means, while the other technicality is pure poppycock, which well-informed China watchers have summarily dismissed.

Europeans (the British in particular) have no idea about what drives their economies because they are poorly informed. Business is hardly mentioned in the broadsheets, except when the politically-correct bank-bonus bashing begins again (Tax payers to underwrite final payments to failed bankers etc). Television newscasters seem to have very little idea what they are talking about when it comes to report on financial markets, and air time is limited to five minutes of fumbling. Compare this to the hours of time spent discussing financial markets in Hong Kong where news channels are dedicated to only discussing the stock market, and where even the main evening news has a special half an hour discussion. Newspapers also have full, separate sections on all aspects of the world’s financial markets. When you tell a European that you are a stock market specialist, their eyes glaze over, and series of apologies about their ignorance follows. This is a very worrying trait, because as Europe’s economies continue to have their manufacturing industries hollowed out by the cheaper powerhouses in the East, financial markets will grow in stature to such an extent that it will overpower everything else in terms of importance to their GDP. This is already very obvious on the ground.

While there is no doubt that unemployment has risen in the UK/Europe, the so called recession, that the newspapers and economists continue to pound on about, seemed very muted. The streets were still crowded with shoppers, and getting served at a shop was particularly difficult, because, while head office may have cut back on staffing levels at the shop floor level because of the losses at their treasury departments, traffic in shops seemed just as high as they were the last time I was in the UK, in the summer of 2006. I have to admit that Oxford is not typical of the whole of the country, but my travels to London and (briefly) Bristol, did not seem to be too much different. Streets were packed of consumers. A visit to Blenheim Palace (cost: 10 pounds a head) on a weekday was typical, with the car park extended to another field to accommodate the number of visitors. Paris was packed as usual, although numbers were supposed to be down 16%. However, this is compared with what? I got the impression that, while there has been a decline in economic activity from the heady, 2 standard deviation days of 2007, if one draws a long term trend line, I would suggest that the line is still pointing upwards, and that activity has simply returned back down to the line. Perhaps then, Europeans’ naivety about financial markets and economics is probably a good thing, because what is happening on the ground cannot be translated into a series of numbers that make sense to the masses. The Labour-backing Daily Express’ headline, “UK recession is over”, of August 13th, was a nice piece of propaganda. The rest of the UK press was busy shoveling out the usual titillation that the masses seemed to need on a regular basis. The Express made it look like the headline was official, but in fact it was only the opinions of a couple of economists.
HS Index and Shanghai Composite

In the meantime, back in Shanghai, the talk of bubbles that has been brewing for weeks, finally spilled over into a sharp pull-back in the Shanghai Composite. It moved from the top of its medium term trend line to the bottom, in quick time. Hong Kong sort of followed, with some very erratic trading in thinning volume. As I predicted on July 20th Investment Weekly – Just what the DR ordered, the A-H Premium Index crashed to an intra-day low of 121 on August 19th. As far as I can tell, the selling in Shanghai was driven by momentum on the downside, from an inflated position. There are no signs that Shanghai has just completed the shortest bull market in history.

As I’m quite convinced that China has not just pulled off the worst bull market in history, I’ve decided to double up on the model portfolio’s investment in China Wind Power. It is not a usual tactic of the portfolio to buy a stock at a price higher than the original entry point, but China is likely to announce more measures to boost its green industries ahead of President Obama’s visit to China in November. The addition will barely add to the risk/reward balance of the portfolio, as the beta has risen to 1.49 since April’s 1.45.

This week’s action, whether in Hong Kong or Shanghai, will be determined early in the week when important moving averages need to be tackled. For the HS index, the 20-day average is a tantalizing 300 points away. A gain of about that amount would lift the index above its parabolic and allow it to test the top of the Bollinger Band of 21,100. However, a move to the top of the band will bring out more profit-taking, allowing the current consolidation phase in the bull market to continue, and thus allowing the bears to continue their attempts to test the resolve of buyers.

#1 Investment Weekly – What reputation

There is a common saying used by the Hong Kong press that sounds daunting each time it is rolled out, but, unfortunately for the doom and gloomsters editors, has about as much bite as a soft cushion/comfy chair. The offending phrase “damaged Hong Kong’s reputation as a global financial center” was blurted out again last week following news that local banks will buy-back Lehman Brothers minibonds to the tune of 60% (rising to as high as 80%) of their face value. There are several conclusions one can derive from the lack of reaction from Hong Kong’s financial markets to the settlement: first, the decision will not actually impact Hong Kong’s reputation; second, Hong Kong doesn’t have a reputation to damage, or, maybe, investors assume China will continue to bail Hong Kong out.

The Hang Seng Index jumped another 6% last week, while the HK$ remained below the strong side of its official trading range to the US$. I suspect that the lack of reaction to the decision to bail out these persistent and naïve investors is because Hong Kong’s reputation is founded on one basic premise: that no matter how many times we cock things up, China will always come to our rescue. In other words, we have a reputation, but it is founded on an unofficial policy of positive interventionism.

The latest so called “dent to our standing” stems from an agreement that local banks will buy back HK$6.2 billion of an investment product they sold to 62,000 retail investors as far back as 2004. The banks will then sell the underlying assets of the CLNs and return any excess (if any) to these investors. There are a couple of issues that need to be noted following the agreement (some of which could backfire on settlement recipients): first, at some point, the banks that distributed the CLNs will have to report losses (which have not been factored into profit forecasts). For example, Singaporean banks settled with their minibond customers at 30 cents to the dollar after selling the collateral. In some cases, these losses could be substantial and will weaken the capital positions of these banks (by as much as 5% according to rough calculations). This will result in less capital available for loans to Hong Kong individuals (possibly the same people that received the settlements). Second, local banks will be very cautious about selling high-margin investment products to investors for fear of having to take further losses in the future. Local investors will therefore lose the opportunity to take advantage of financial product innovations, thus losing potential income. Local bankers are sure to blacklist settlement recipients from future banking facilities and investments. Ironically, some of the staff selling these products (possibly relatives or friends of settlement recipients) would have been laid off because of the naivety of these investors and the soft headedness of Hong Kong’s politicians. All these outcomes are bad news for the Hong Kong economy, but no one seems to care. Finally, the selling pressure on the underlying collateral (which apparently consists of CDOs, other asset-backed securities and other obligations that are worth far less than their original values) will be severe as the banks scramble to realize cash. The whole selling process will take 90 days (60 days to accept and 30 days after that to sell). Although the amount to be sold is not large compared with the total asset-back securities market, someone out there may not be aware of the reason for the selling and it might spark a panic.

If the outcome is so negative, why has the agreement been ignored by the market? Probably because the list of blunders by Hong Kong’s great and good has become so long and odious that overseas investors have become immune to these policy mistakes and dodgy dealings and assume, with impunity, that, no matter the amount of mess or the size of the dent to Hong Kong’s reputation, mother China will coming running to aerosol over the stench. Last week’s pong was preceded by the waving of the first train into Hong Kong’s Exchange Square terminus (see Investment Weekly – Just what the DR ordered). Last week, China announced subsidies for mass solar panel installation, thus providing a boost to its green credentials and giving an excuse for overseas investors to talk up the green potential of a massively over-polluted fast-developing nation. This newsletter has recently added a fair weighting of green stocks to take advantage of these new inflows into the market before this particular bubble bursts.

The new talk around town recently has centered on possible bubbles in Greater China’s asset markets. It is amazing to believe that only nine months after the world’s financial systems almost imploded that the bulls now have to fend off discussions about double dip recessions and asset prices having risen too high too fast. It has to be said that the bulls are unfazed by such talk, judging by the surge in stock market volume in recent weeks. The bears, such as Roubini and Taleb (notice how Middle Eastern, and therefore ominous and troubling, their names sound now) have been almost completely absent from the business pages recently – although I did see Roubini predict on April 18 that the “bottom is a year away”. These terrible two did see the bear turn correctly, but, because they are constantly depressed, they did not pick the upturn in the world’s financial markets and are now having to cower and eat large amounts of humble pie. Their reputations have been damaged because they did not spot the turn in the world’s financial markets in March and they do not have anyone to hide behind. These mavens will not be listened to again until the top of the next market, when the bubble has been puffed up to full potential and headline writers need some justification to back their claims that the top of the market has arrived.

Unfortunately for the bears, the top of the market is still a long ways off. This means that, although this newsletter will be taking a two week break as the author takes a vacation, there will be no changes to the model portfolio.

#1 Investment Weekly – Just what the DR ordered

There was only one headline worth reading last week, and its effect was a 9% surge (1,551 points) in the Hang Seng Index. The gist of the article on Wednesday was that finance officials in Shenzhen are proposing a new cross-border scheme that would allow mainlanders to invest in the Hong Kong-listed H shares of mainland companies through depositary receipts (DR) traded on the Shenzhen stock exchange.

The initial reaction was equal to 41% of the subsequent gain in the Index, and was powered by a small belief that the headline was reference to some sort of “through train”. This perception was quickly scoffed at by op-eds as a red herring. I suspect that they are wrong, because the markets are saying something quite different as the chart below illustrates.
“Shenzhen through train” performance

The clear outperformance of the H-share-heavy HS Index relative to the Dow or the Shanghai Composite suggests that investors see the DR proposal as a green light to buy. So, while the Dow recovered on strong earnings from US banks, the Shanghai Composite lost ground as mainland investors switched to Hong Kong H shares in anticipation of the introduction of DRs in Shenzhen. This switching explains the relative performances of the usual benchmarks for the HS Index last week. The extra 4-5% of outperformance was purely due to the DR announcement.

The concentration on H shares explains why, unlike the direct investment proposal put forward with the original through train in mid-2007, the only beneficiaries of the DR proposal would be H shares. This explains why overall market turnover did not match the surge in the H share heavy index. The market’s average daily volume actually fell 4% compared with the prior week, but turnover rose 9% due to the rise in higher priced H shares.

As with the mania in mid-2007, mainland investors will be keen to buy H shares because they are trading at a discount to their equivalent A shares. The current AH share premium index is trading at 141%, with many stocks trading at premiums of 70-80%. The AH index fell 3.8% last week, having hit a high of 148 and a low of 135 last month. If the DR story continues, then a continuation down to the recent low is a necessity to confirm the view of the market. The only false signal to appear from last week was the relative strength of HKEx (which matched the index’s 9% jump). Although the stock exchange will benefit from increased demand for H shares if the DR scheme is implemented, investors were probably getting ahead of themselves if they believe that the proposal from Shenzhen will lead to a direct through train (which is when HKEx will truly benefit). As mentioned earlier, turnover actually fell last week.

AH Premium index

Action for the rest of the market last week could be characterized as sloppy, with so much attention paid to the DR story. Boosted by the DR theme, the HS Index reversed some technical weaknesses and bounced back above its 18,300 fair value level and the 20-day moving average was retaken. But breadth and turnover were not indicative of a plausible rally. These indicators will need to pick up strongly this week if a break above 19,000 (which would put the index well into overbought territory) can be sustained.