Despite all the positive press that China’s “Economic Rising” has garnered lately, investing in China has been a slog since August of last year. As one can see from the chart of the Shanghai composite below, China’s equity markets have been pretty sloppy since last August. China shares are not particularly cheap with most consensus forecasts suggesting P/E’s in the mid 20’s for a slice of the action.

From the System’s point of view, the high volatility and lack of upward direction has relegated China assets to the bottom half of the rankings for all the portfolios that include China for several months. However, after losing 13 plus percent in a month, China this week has tipped into the Short column in our Asian Index Long Short portfolio.

Shanghai Composite

Source: Bloomberg

Why is this happening when the press reports are in near universal awe of China’s ability to navigate through the Global Financial Crisis? China, after all was swift to turn on the liquidity pumps at the banks to inflate a property bubble of impressive proportions. Despite the continued weakness in China’s primary export markets of the US and Europe, companies were eventually compelled to restock shelves in the past few quarters leading to a nice snapback in export orders.

But the markets are forward looking and if one scratches beneath the veneer of good news, there are problems a plenty. The largest problems are tied to inflationary pressures (primarily from an overheated property market) and the sustainability of economic recovery in China’s two biggest export markets (the US and Europe). But the latest drop appears to be anticipating something more specific. China’s banks have all been ordered to raise more capital (slowing down loan growth is not really an option) and China’s Agricultural Bank is slated to become the largest IPO ever at US$20-30bn. The initial idea is a dual listing in Hong Kong and Shanghai in July but over the past few sessions, there has been enough talk about Plan “B”s to suggest a bit of indigestion ahead. A shaky launch could be the catalyst to send China shares into a swoon (with impact on the Hong Kong market in general).

So what is the bet?

Defining what you are trading on is very important because there can be several outcomes. If you are unclear about the original conditions, it is unlikely that you will be able to react properly to the outcomes. The bet is that China’s regulatory officials feel comfortable pushing ahead with the Agricultural Bank IPO and other fund raising activities at a time when international appetite for risk is waning. That doesn’t mean the IPO has to fail miserably or even get launched at all. It means that the presence of the deal (the overhang) will cause indigestion in the market and cause prices to fall. Why are the Chinese authorities feeling confident? For one thing, property prices are rising in double digits in almost all the cities. For another, China’s leaders are busy trying to batten down talk of the “Beijing Consensus” or “China Model” as they swan around the world with a bit of a G2 swagger. In short, the bet is about a bit of hubris in the market which will be corrected in the time honored fashion of falling prices.

How to play this opportunity?

For the average investor, it is quite difficult to short the market. Products do exist. Proshares offers YXI and FXP, the inverse and double inverse of the FTSE Xinhua 25 index, FXI. However, one should read the well written and un-camouflaged health warning on the Proshares site carefully. Because the inverse ETFs are designed to track one day movements in the underlying index, a volatile market like China can lead to large tracking errors between the ETF and the target index over relatively short stretches of time. Some investors will choose to short FXI in a margin account to try to obtain a better tracking over periods of one month or so.

Should you play this opportunity?

If you decide to short anything, you need to pay closer attention to it than a long trade. For many investors, the extra attention to detail is the dealbreaker. If you are not sure, err on the side of caution. If you are ready to play, you first need to consider how FXI will diverge from SSEC (the Shanghai composite index). While it is true that the FXI is made up of the bluer chip companies that are able to meet Hong Kong’s listing standards and that the P/E ratio is lower (16.7 at the end of April) than those in Shanghai, the FXI is heavily weighted in precisely the same financials that will be impacted by a less than stellar Agricultural Bank launch.

For those who are unwilling or unprepared to go short, there is still a good opportunity on the long side. If IPO indigestion tanks the market, there will be a good chance to pick up shares in the second largest economy (and largest exporter) on the cheap. When will that happen? Watch the System rankings in the coming months. When China starts to move off the bottom of the list, there may be a good opportunity to catch a rebound. Why do we think there will be a rebound on the other side? Because our central investment premise is that markets move in cycles. If this cycle is a down one for China, it makes sense that the next one will move in the opposite direction.

Not perfectly correlated

Shanghai Composite vs FXI ETF

Price Source: Reuters

Other trades this week

Not a lot has changed from last week. Emerging Europe, Japan, India, US Small Caps, Biotech and High Yield are still hanging in there. One subsector which has scored well lately is the Homebuilders (XHB) in the US. Homebuilders are reported optimistic despite phased out government incentives to new home buyers. In our commodities only ETF portfolio, Gold (GLD) and Silver (SLV) shine in an otherwise dull clutch of investment opportunities. However, in mixed portfolios, neither precious metal ranks highly.

Filed under: AsiaBRICChinaEmerging MarketsETFInvestment Product

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