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Everything You Need To Know About The Chinese Stock Market Bubble

This post first appeared on The Felder Report Premium on June 20, 2015.

I’ve mentioned the Chinese stock market mania here briefly in recent weeks. I’ve now compiled a fair amount of data along with some interesting anecdotes that show just how crazy it’s gotten so I thought I’d spend this week’s market comment laying it all out for you.

The first thing I like to focus on is valuations. If the dot-com bubble is the gold standard, then China is a bona fide financial bubble. According to Bloomberg:

Valuations in China are now higher than those in the U.S. at the height of the dot-com bubble just about any way you slice them. The average Chinese technology stock has a price-to-earnings ratio 41 percent above that of U.S. peers in 2000, while the median valuation is twice as expensive and the market capitalization-weighted average is 12 percent higher, according to data compiled by Bloomberg.

Another way to look at it is to compare current valuations around the world:

I’ve made the case that US stocks are more overvalued than they appear due to the fact that the median stock is now more highly valued than ever. There’s now a very similar but far more dramatic situation going on in China. Again, from Bloomberg:

The problem with the Shanghai Composite is that 94 percent of Chinese stocks trade at higher valuations than the index, a consequence of its heavy weighting toward low-priced banks. Use average or median multiples instead and a different picture emerges: Chinese shares are almost twice as expensive as they were when the Shanghai Composite peaked in October 2007 and more than three times pricier than any of the world’s top 10 markets.

So if US stocks are expensive on a median basis, Chinese stocks are incredibly so. What’s pushed valuations so far is euphoria like we may have never seen here at home. More than any developed stock market in the world, China’s is driven mainly by individual investors rather than institutions. This means that it’s probably more influenced by what Keynes termed “animal spirits” than most. And boy are there signs of those “animal spirits” in China today.

The number of new trading accounts being opened is simply stunning. I don’t know if I’ve ever seen a more dramaticly parabolic rise in anything.

And they’re not just buying stocks with cash. They’re using an incredible amount of debt, aka margin financing, to leverage their purchases right now.

What I find so stunning is that there are really no margin regulations on individual trading accounts. Yes, the brokerage firms all implement their own sort of margin limits mainly to cover their own asses but the regulators essentially allow for infinite leverage. In other words, it’s 1929 in China right now. The regulators are now considering implementing a 4-to-1 ceiling. To put this in perspective, the SEC allows for 2-to-1 leverage for US investors. Still it’s pretty plain to see what exactly is driving prices higher right now:

Though they make up the majority, it’s now gone far beyond individual investors. The Wall Street Journal reports that some manufacturing companies in China have completely shut down their main operations and put their cash to work in the stock market. Fully 97% of the growth in manufacturers profits now comes from this source of “income.” It’s hard to fathom just how insane this is: Manufacturers realizing they can make more money trading each others’ stocks than actually running their manufacturing businesses.

It’s also the growing popularity of index funds pushing prices to astronomical levels. A great example of this was the recent trading in Hanergy and Goldin Financial. Here were a pair of stocks that everyone knew were extremely overvalued. But they grew to a size that required index funds to add them to their portfolios. Now consider those valuation statistics above. 94% of Chinese stocks are valued more highly than the index. How many of these have also grown to a size that requires them to be purchased by index funds? I guess we probably won’t find out until the dust settles.

And if you think all these new traders and index funds, which are clearly at the mercy of some pretty hot money, are long-term investors, think again.

These guys make our dot-com era day traders look like Warren Buffett. The Chinese stock market just set a record for the shortest average holding period in history, just one week.

For some context here’s what happened to Taiwanese stocks after they witnessed the sort of frenetic turnover now driving the Chinese stock market. They fell about 80% over the course of just 8 months or so:

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“So how did we get here?” you may ask. I’ll let the FT explain:

There is one sense, though, in which euphoria in mainland Chinese equities is unusual. Far from being an unintended consequence of policy, the authorities are egging investors on with articles in the state-run press seeking to justify extreme valuations. The People’s Bank of China has been busy cutting interest rates.

And they have not yet cracked down on the incredible leverage being used by individual investors. The powers that be in China have carefully cultivated this incredible bubble. The reason they have done so is that, after the huge boom they have created over the past 20 years or so, they are now facing a potentially huge bust, especially in real estate (sound familiar?).

John Hempton recently wrote a blog post about his personal experiences with the incredible over-investment in China that is now coming home to roost. It sounds like Potemkin Villages on steroids over there.

And companies have been continuing to lever up even in the face of a deteriorating economy.

…until very recently.

So the equity bubble is a desperate attempt to avoid or at least ameliorate the damage of the economic bust the country now faces. The FT reports:

Why, you might ask, would those charming officials in Beijing wish to encourage a bubble? A consequence of the investment boom is that many state-owned enterprises are lossmaking, while state-owned banks have lent excessively to these companies and to local governments. The authorities are urging them to lend more despite the fact that they will never be repaid in full. The obvious way to de-risk this dangerous game of extend and pretend is to recapitalise the state-owned corporate sector. Bubble valuations will make this easier and cheaper.

Will it work? That is the $64,000 question. Still, I think it’s fairly easy to answer. Every other bubble in history has ended the same way. It’s popped. For the Chinese authorities to think they can avoid these consequences is probably fairly naive. Still, their grip on power over the country may depend on it so I don’t expect they stop short of doing whatever it takes to keep the game going. Having said that, once sentiment turns against the markets, it’s probably impossible for anyone to stop it.

Hanergy may actually provide a decent example for what that looks like. Once the game was up, it ended in a flash – literally less than a second.

Amazingly, the person who may have take greatest advantage of the situation was the company’s Chairman, Li Hejun, who shorted a boatload of his own company’s stock just prior to plunge.

Li is not alone. Reuters reports that Chinese corporate insiders are selling at a record pace.

In May company insiders – senior executives or their relatives – sold a combined 1.68 billion shares, a tripling from April, and much more than in each of the previous months of this year, according to data compiled by Reuters… A similar trend was captured by an index compiled by Shenwan Hongyuan Securities that tracks major shareholders’ trading activities. The index surged over the past month, to a record high, meaning major shareholders are reducing holdings at unprecedented levels.

It looks like all those individual investors, manufacturers-turned-day-traders, and index funds are going to left holding the bag. Last week the market lost 12.5%. A few weeks ago I suggested the ETF below had potentially seen blowoff-type volume. Now I’m even more convinced. And I wouldn’t be surprised to see a Taiwanese-style bust over the next 6 months or so. sc-6On a broader level, if this is the end of the Chinese equity bubble it has major ramifications for every other market and economy around the globe. For this reason, I expect more market participants to start paying very close attention.

We’ll just have to stay tuned and see how it all unfolds.

Disclosure: I own put options on ASHR.

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Calling All Bulls

It’s no secret I’ve been bearish but in the spirit of seeing the other side of the trade, I’ve been looking for a compelling bull case for equities for some time now. So this is a call to all the equity bulls out there. I’m looking for someone to make a compelling case for owning the broad US stock market over the next 3, 7 and/or 10 years.

I’m using these timeframes because I’ve shown here that margin debt suggests 3-year returns could be very poor. Jeremy Grantham’s shop, GMO, believes 7-year real returns will be negative. And there are plenty of measures that suggest 10-year returns should be close to zero. In fact, if the Fed is right, and demographics do matter to asset prices, returns over the coming decade could be significantly worse than zero.

Here are the ground rules. Any bullish case for equities under consideration here should:

  1. Be more than just a trend-following argument. I know the uptrend is in tact but that, in itself, doesn’t mean investors are likely to generate positive returns in coming years.
  2. Do more than simply criticize the CAPE (which is not even mentioned above) or any other measure, for that matter. Debunking any of my previous studies is welcomed but that’s not going far enough. It should make the positive case for owning equities going forward.
  3. Demonstrate, using some sort of historically valuable (meaning more than merely one prior occurrence) measures, that equities will likely outperform the risk free rate over any of the aforementioned time periods.

Send your responses here. I’m eager to see what you come up with. I’ll select a few that meet this criteria for publication here.

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The Most Crowded Trade On Wall Street: Denial

A version of this post first appeared May 2, on The Felder Report Premium.

“It just doesn’t matter.” This is the mantra of the bulls who, no matter what bearish evidence is presented, simply insist, “earnings don’t matter. Valuations don’t matter. Margin debt doesn’t matter. Market breadth doesn’t matter.” You name it and they defame it. I was recently told by a bull who was dead serious that, not only do none of these things matter, there is an invisible magical force more powerful than any of these them which ensures stocks will continue to march higher. I was dumbfounded.

These are only a small sampling of the refrains from the “it just doesn’t matter” chorus that is the rallying cry for all the bulls buying even the slightest dips in the stock marketright now. I actually agree with this sentiment much of the time. Certain aspects of the market or individual indicators like these don’t usually matter to the market, as they say, until they matter. But when is that? Ironically, I believe that they typically begin to matter just when everyone begins to believe that they won’t matter ever again (just another version of “this time is different”) – which is right about now.

It’s simple contrarianism at work. The more popular an idea or chart becomes the less likely it is to “work.” Take the popularity of “sell in May,” for example. It’s become so popular over the past few years that it’s just stopped working. Ironically, now that the bulls begin to mock the concept it may just start to work again. The same goes for, “[fill in the blank] doesn’t matter.” As soon as everyone begins to believe something doesn’t matter to the markets, the markets will shortly prove them wrong.

So let’s take a look at each to see how they actually might begin to matter to the stock market today. As Fred Hickey recently wrote, even respected strategists like Well Fargo’s John Manley insist earnings don’t matter. This can be true over the short run when the market is a voting machine. However, over the long run, as Ben Graham famously said, the market is an earnings weighing machine. But even over the short run, the market is constantly assessing and discounting the future growth of earnings:

The chart above shows that slowing future earnings growth doesn’t currently matter to the market but that this is also a rare divergence that is likely to be rectified sooner rather than later. (If the forward p/e were to catch up the decline in estimated earnings growth, as indicated in the chart, stocks would fall about 35% fairly quickly.)

The Financial Times recently ran an article insisting valuations don’t matter. This is something I hear from naysayers all the time. I guess this just depends on your methodology and time frame. Pure trend-followers care nothing about valuations nor do short-term traders. For everyone else, though, valuations are the best possible measure of potential risk and reward and are very highly correlated to future returns. The simple fact that it is so popular to deny this iron law of the markets may be the greatest contrarian warning signal there is.

It’s also become popular to defame the concept of market breadth. Breadth simply measures the participation rate of a given trend and assumes the trend is strongest when there is the greatest degree of participation. Waning participation in a trend is sign that it’s losing momentum. There are many ways to measure breadth and I believe the greater variety used, the more meaningful the message.

The chart below shows the S&P 500 along with the percentage of stock trading above their own 200-day moving averages and new highs and new lows on the New York Stock Exchange and the Nasdaq. Individually, these indicators are not very effective. When all three begin to wane in the face of rising stock prices, however, it has been a bad sign for stocks going forward.

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Additionally, bond market risk appetites and volatility are both diverging from stocks at this point, too.

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It’s easy to argue any one of these is not very meaningful on its own. Each can send many “false positives,” as my friend Jason Goepfert likes to say. Having said that, when they all point the same way, it’s hard to make the case that they “don’t matter.” In the past, this has been a very clear sign that stocks are running out of steam. Again, the fact that it’s become popular to deny this truth is a sign that it could be about to prove its worth once again.

Dow Theory is another concept related to market breadth that has been widely dismissed recently. I wonder, however, if those dismissing it have seen this Nautilus study. Over the past 50 years we have only witnessed a similar divergence between the Dow Industrials and the Transports on two prior occasions. Those marked the stock market peaks of 1973 and 2000.

Finally, a few popular bloggers have recently published pieces claiming margin debt is another useless metric. The common response to the famous margin debt chart is, “that’s been true for years and it hasn’t mattered.” Saying margin debt doesn’t matter is the very same as saying that supply and demand don’t matter to an asset’s price. It’s asinine. Nothing matters more to price than supply and demand!

As a clear indication of potential supply and demand for stocks margin debt is absolutely critical to prices. Extreme levels of margin debt clearly indicate very little potential demand left for stocks and very high potential supply and vice versa.

From a purely statistical perspective, margin debt is very meaningful. As I recently wrote, margin debt relative to GDP is very highly correlated to future 3-year returns in the stock market. In the past, the current level of margin debt has led to stock market declines of about 60% over the coming 36 months. Once again, the fact that it has now become so popular to dismiss margin debt as meaningful means that we are likely approaching a tipping point.

I just can’t stress enough how the sentiment surrounding an indicator can be far more important than the indicator itself. I have found this to be especially true with chart patterns. The more eyeballs there are on a given pattern the less likely it is to work. A chart pattern is most effective when it is ignored, dismissed or simply missed by the masses.

Right now the masses are ignoring, dismissing or simply missing a wide variety of meaningful signals suggesting the stock market is likely in the process of forming a major top. To me, this makes these signals that much more poignant.

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3 Uber-Bearish Studies Foreshadow The Death Of This Bull Market

There has been a lot of discussion regarding the waning breadth of this stock market advance as it has set marginal new highs lately. Taking a step back I find it interesting to note that after an explosive 2013 advance, stocks began to lose momentum last year. The first half of 2015 has now seen the narrowest trading range in the history of the Dow Jones Industrial Average.

As a young kid one of my favorite toys to play with during the summer was a water rocket. It was just a little plastic, red rocket you would pour a bit water into and then pressurize with a hand pump before launching into the air. It feels as if the market is sort of like one of those rockets that has approached the apex of its flight. It’s now at the very short period of time where it’s almost frozen in the air before descending back to earth.

I recently came across a few studies which suggest this metaphor might be more apt than you may initially believe. Those of you who have been reading this blog for at least a few months know I like to look at not just fundamentals but sentiment and technicals, as well. These three studies fit this pattern.

Starting with sentiment, many pundits have been quick to dismiss margin debt as a useless indicator. However, I believe it is a very good indicator of investor sentiment. When they are eager to take on debt to fuel additional purchases of risk assets, clearly sentiment is more euphoric. When investors are keen to pay down margin debt the opposite is true. Ultimately, for this reason I believe margin debt is a very good indicator of risk appetites and potential supply and demand for stocks.

The statistics support this idea. As I recently demonstrated, margin debt relative to GDP has a very high correlation to future 3-year returns in the stock market. Right now, margin debt is forecasting about a 50% decline in stocks over the coming 3 years:

Next, in our technical study, the Dow Theory has been another one pundits have loved to hate lately. Even while the Dow Industrials have recently made new highs, the Transports have made a new 6-month low. Over the past 50 years, this sort of divergence has only happened at the 1973 and 2000 peaks, just prior to epic bear markets.

Finally, John Hussman recently overlaid a fundamental filter on top of a tight range study like I mentioned earlier. He finds that when stocks have traded so narrowly while being as highly overvalued as they are currently it has signified nearly every major stock market peak of the past century including 1929, 1937, 1965, 1973, 1999-2000 and 2007-2008:

Ultimately, the evidence is piling up and on many fronts (fundamental, sentiment and technical) that this bull market’s days could be done. Not only that, but the second-half of this full market cycle (busts follow booms like night follows day) will not be too different from what we should now have become accustomed to witnessing over the past 15 years.

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Why It’s So Important For A Stock Operator To ‘Know Thyself’

“A stock operator has to fight a lot of expensive enemies within himself.” -Jesse Livermore

Over the weekend I came across a brief interview with Bill Gross published in the New York Times, in which he says, “There was an old dude, Jesse Livermore, who wrote a great book that said the most important thing in investing was to know yourself — your weaknesses, your flaws and your strengths.”

I thought about that for quite a while after reading it. I read Reminiscences of a Stock Operator a long time ago and didn’t quite remember the book the way Gross did. But thinking about the Gross quote, I realized that all of my greatest trades have been the result of taking advantage of my greatest natural strengths. All of my greatest mistakes have been the result of not recognizing quickly enough the natural weakness that was at the root of the losing trade.

I decided to actually put pen to paper to consciously explore what I believe are my natural strengths and weaknesses. This, to become more acutely aware of them in order to better actively take advantage of my natural strengths and avoid or ameliorate my natural weaknesses.

Here’s what I believe are my natural strengths:

  1. A willingness to go against the herd. More so, a natural skepticism toward what’s popular.
  2. An ability to see points of view or arguments on their merits, without logical biases.
  3. Confidence in my own research and abilities.
  4. A natural inclination towards unloved and overlooked opportunities.
  5. A deep passion to constantly learn and improve.

Here’s what I believe are my natural weaknesses:

  1. I have a hard time staying with there trend, especially once it becomes popular.
  2. At times I can be too skeptical or focus too much on worst-case scenarios.
  3. I can be overconfident even when the market tells me I’m wrong.
  4. I tend to look for confirmation of my point of view rather than opposing views.
  5. At times I seem to care more about being right than making money.

Over the years I’ve managed to address many of these weaknesses. There isn’t any trader who is even mildly profitable who hasn’t been able to do this at least to some degree. But writing them down, putting them on paper somehow helps to compartmentalize them and, more importantly, address them directly.

I realized that consciously addressing them by coming up with tactics to ameliorate them might give me the opportunity to turn my natural weaknesses into developed strengths (as opposed to natural ones). This is something I’ve also done subconsciously to an extent but to do it consciously and methodically could potentially magnify the benefits.

Taking each natural weakness one by one:

  1. Hard time staying with the trend – Modify my sell discipline to take advantage of the long-term trend. So long as there is no compelling reason to sell we will continue to hold until the long-term trend changes.
  2. Too skeptical – Don’t let macro worries get in the way of good micro opportunities. It’s okay to ‘worry top down’ so long as you continue to ‘invest bottom up.’
  3. Overconfidence – Confidence is great and even necessary but humility is just as important. You must respect the market even if you don’t defer to it.
  4. Confirmation bias – The greatest investors regularly seek to understand the other side of a trade even better than those taking it. Spend far more time studying the opposing view.
  5. Being right versus making money – Regularly admit you’re wrong even in the smallest cases. Make it a habit so that acknowledging a mistake and moving on can happen very quickly.

These natural weaknesses are precisely the “expensive enemies” Livermore wrote about. But by ‘keeping your friends (natural strengths) close and your enemies (natural weaknesses) closer,’ in this way I believe a stock operator gives himself the best opportunity to find success in the markets in his own unique way.

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