Is there anything the Chinese authorities haven’t tried yet in their attempt to manipulate the Shanghai stock market back up again? Off the cuff there’s nothing we can think of, except maybe shutting the market down entirely.
As we have previously pointed out, Chinese investors have fallen prey to the “potent directors fallacy” (a fortuitous term once coined by Robert Prechter) – in fact, China is currently a prime example of this fallacy in action. The term essentially describes the misguided belief that political authorities can somehow suspend economic laws or will always be successful in manipulating financial market trends.
A Chinese retail investor, evidently shocked that the potent directors still can’t keep prices from falling
Photo credit: China Daily / REUTERS
The truth is that they can never stop a primary trend from unfolding. This is not to say that they cannot succeed in manipulating market prices at all – in fact, they will usually succeed in doing so over quite lengthy time periods. Given that the authorities have control over money supply growth and administered interest rates, they can certainly provide the necessary tinder to make asset prices rise or stop them from rising. But preventing a decline of an overvalued bubble market in which thousands of inexperienced traders are long on margin is a very tall order indeed, and the actions taken by the authorities appear to be backfiring in this case.
The Shanghai Composite falls by nearly 8.5% overnight – click to enlarge.
The biggest mistake the authorities made was to ban certain investors from selling. The victims of this edict were mainly institutional investors in China, over which the authorities can exert leverage relatively easily. This immediately raises a rather vexing question for every other investor, namely: will they ban me from selling next? The rational reaction to this dilemma is “let me get out at the earliest opportunity”.
Similarly, new buyers are now reluctant to buy the dip, because they must also fear that they could eventually end up locked into the market by government fiat. Obviously this is a fate one would rather avoid. Foreign investors with flexible investment strategies such as hedge funds are likewise scared off, as they are no doubt aware that they are usually among the first to be assigned the role of scapegoats.
However, as we have also pointed out previously, there is very likely no way the authorities can prevent a bust in China at this point. Here is a video of Asianomics Deputy Chief Economist Sharmila Whelan discussing China’s emerging bust on Bloomberg. She’s right in our opinion, and a major reason why malinvested capital is now suddenly unmasked in China is that the government’s laudable attempts at reform have had the side effect of dramatically slowing the country’s money supply growth rates:
China’s money supply growth rates have plummeted – click to enlarge.
No matter what the authorities do here and now, they can no longer prevent the lagged effects from this slowdown in the growth of credit and money from playing out. The best they can hope for from their own perspective is that they will be able to reverse the trend with a lag – and a lot can happen until then. One should by the way be careful in interpreting the meaning of cuts in minimum reserve requirements and other easing measures by the People’s Bank of China.
Reserve requirements have been the PBoC’s main tool for “sterilizing” the massive capital inflows China has experienced up until fairly recently. Since the central bank buys dollars received by exporters and sellers of Chinese assets with yuan it creates from thin air, it has to do something as an offset, so as to keep domestic money supply inflation under control. Raising reserve requirements has a “reverse multiplier effect” in a fractionally reserved banking system, while lowering them has the opposite effect. In short, the central bank is merely trying to counter the effect of recent capital outflows from China. Net-net, there is probably not much of an easing effect, at least not yet.
A Possible Light at the End of the Tunnel?
In concert with the steep downturn in China’s stock market, the decline in commodity prices has accelerated as well. Since China is widely seen as the most important factor in global commodity demand, the politburo’s decision to alter the country’s economic model away from its strong reliance on outsized investment growth, has inter alia produced tough times for crude oil, iron ore and copper producers.
However, current commodity prices may in a way actually represent a light at the end of the tunnel for China’s stock market and other emerging markets. Sectors like commodities and emerging markets are currently widely hated among both institutional and retail investors. So there is a bit of a contrarian case to be made for these markets from a sentiment perspective. To be sure, the fundamentals look bad, and the downturn is probably not over just yet. However, one must always keep in mind that prices will tend to turn before fundamentals take an obvious turn for the better.
An example for this are reported inventories of various commodities. The prices of crude oil and copper, to name two commodities about which fairly extensive inventory information is available, as a rule turn well before the peak (or bottom) in inventories is actually reached. Currently there is admittedly very little fundamental or technical evidence that would suggest that a turn may be near, but the sector is so severely oversold and sentiment so lopsidedly bearish, that it is time to pay close attention. Note in this context an RSI/price divergence that has recently developed in the CRB Index:
A fairly sharp price/RSI divergence has recently put in an appearance in the still declining CRB Index – click to enlarge.
A similar technical signal can be observed in copper:
Copper also sports this price/RSI divergence, which signals waning momentum – click to enlarge.
A caveat to this is that commodity price trends have a tendency to be highly persistent. Given that a lot of capital malinvestment has taken place in the sector, many highly indebted producers now find that they are unable to curtail production, for fear of becoming unable to service their towering debt loads. In short, a supply response is only likely to arrive with a considerable delay.
This situation may be worst in the crude oil market, where governments have control over a vast proportion of production. Since many of these governments are autocratic and depend on oil revenue for their spending – which they use to keep their subjects from thinking bad thoughts – they are under even greater pressure not to lower production. On the contrary, they seem to be trying to make up for lower prices by selling larger volumes. The result is that the oil market is vastly oversupplied in the short to medium term.
Finally, there is one more benign signal for Chinese stocks, and that is the action in the Hong Kong stock market. Mind, it is always possible that Hong Kong will only react to the decline in Shanghai with a slight lag, so this signal may not be overly meaningful just yet. We would however argue that if e.g. the Shanghai market were to eventually put in a slightly lower low accompanied by a higher low in the HSI or vice versa, such a divergence could be a useful heads-up for those contemplating a little knife-catching in emerging markets or commodities for a trade.
The HSI diverges positively from Shanghai by declining a lot less, at least for the moment – click to enlarge.
Having said all that, the technical evidence discussed above is not strong enough yet. It is merely a first hint that one should pay attention to a potentially developing opportunity in sectors no-one currently likes. Usually buying assets absolutely no-one likes tends to be a long term profitable strategy, but one must keep in mind that the crowd tends to be correct for large stretches of strong trends, so proper timing is still an issue. Currently we would expect a playable bounce to be at hand relatively soon, but it will likely take some time before a major trend change can be established.
Conclusion
In light of weak money supply growth in China over the past two years, the authorities are probably fighting a losing battle against the emerging bust. Although China’s government has a great degree of control over the economy and markets in the country, it is not omnipotent and cannot suspend economic laws.
China actually needs a bust – nothing would be more conducive to bringing the economy back on a sound long term footing, although it will undoubtedly be quite painful in the short to medium term. In spite of its comical and counterproductive attempts to stem the slide in stock prices, China’s government has so far resisted calls from assorted liquidity junkies to provide more money and credit – this is borne out by the actual data, as well as occasional comments by PM Li Keqiang, who seems by and large intent on continuing with the reform course.
The PBoC’s easing measures have to be brought into context with the fact that China is suffering capital outflows of late. On a net basis, there has actually been very little easing and there has definitely been no serious attempt to once again blow up the money supply. This is a major reason to remain wary of both China’s stock market and commodities, even though a playable counter-trend move could be in the offing fairly soon.
As an aside to this: materials and energy represent some 15% of the total market capitalization of the S&P 500 and have been a major reason why the index has recently weakened. In other words, in spite of China’s closed capital account, the decline in its stock market and a slew of weak economic data releases have an indirect effect on stock markets elsewhere in the world. We will shortly discuss the intra-market divergences in the US stock market in detail.
Charts by: StockCharts, BigCharts, St. Louis Federal Reserve Research
