At this point, you know the drill. China has been in the midst of epic fiscal and monetary policy for years in an attempt to spur investment, create a wealth effect and attempt to halt their declining growth rate. I think it is safe to say this resulted in a commodity bubble, a debt bubble, a housing bubble, and ultimately a stock market bubble in China. Aside from the end of the U.S. QE, it’s fairly indisputable that the global commodity bubble burst was also in large part the result of a slowdown in unnecessary development in China, but the jury is still out on the timing of the burst of the debt, property and stock market bubble.
The Shanghai Composite’s 135% rise off its 52 week lows a year ago, to its subsequent drop of 30% from the multi-year highs in June can clearly be categorized as an investment bubble when you consider the weak economic backdrop in China.
Calling the timing of the burst of said bubble will be a much tougher endeavor. The Chinese government has enacted unprecedented actions to halt stock market declines, starting with funds set up by regulators to buy shares, investment funds commitment to buy shares and not sell them for a period of time, the halt of ipos and secondaries, the suspension at one point of 30% of listed companies (now about 18%), a ban on short selling… and I’ve probably missed a few. The point, plain and simple, is that the Chinese government is very afraid of a stock market collapse. Despite conflicting data about actual retail ownership of stocks the government’s actions speak louder than any data guesses.
I would add another point here. For those of you who think that technical analysis is a bunch of mumbo jumbo, I would suggest that those in China who are attempting to halt the stock market crash are very in tune with technical support and resistance. The one year chart of the Shanghai Composite shows the early July bounce of the stock’s 200 day moving average (circled), which also happened to correspond with the prior breakout level from March, and then again just yesterday bouncing off of the 200 day moving average:
My view is simple, if we walked in tomorrow and with all of the above regulations repealed, the Shanghai Comp would crash. Obviously that’s not going to happen. But how long can the Chinese continue down this path? Sooner or later the house of cards will crumble. Right?
The issue will be timing on this trade, but I assume every loosened regulation will be met with investors looking to exit the most rigged casinos on the planet, one which the house has no intention to lose. At some point the whole thing will collapse under its own weight. The only way it works is if the government can somehow support the wealth effect long enough for the economy to miraculously recover. But the sad fact of the matter is that’s nearly impossible after everyone from farmers to shop owners got sucked into this mania. And the damage being done to the psyche of foreign investment in China could take decades to undo.
So what’s the trade? We have discussed the Deutsche X-Trackers Harvest etf (ASHR) which tracks the CSI 300 equity index on a few occasions (here, here and here), and I still believe this is probably the best vehicle to express a view here in Chinese A-Shares. But you’d have to be nuts to short it with unlimited risk. It’s a very expensive borrow, and stocks that make the ETF are subject to massive regulation. For those looking to define their risk in the ASHR, it is important to note that options prices are very expensive for all the reasons above, despite have come in hard of late, with 30 day at the money implied vol down from 85% to 60%!
Its my view that when the Shanghai breaks recent support it will break hard, possibly re-testing 3000, with the ASHR re-testing the low $30s. But timing is extremely difficult and you’re always one headline away from looking dumb the next morning for not being more patient. We want to be patient in this and catch this thing after a couple of up days in a row. When we do decide to wade in we have to somehow structure a trade to avoid getting reamed on the hard to borrow skew in the puts. One decent way to do that is a diagonal calendar that could be continually rolled in order to try to bring that breakeven higher while waiting for the Chinese government’s extraordinary actions to run out of steam.
Here is how I would play right now, risking what I am willing to lose. I’m not trading this just yet, but simply looking at structures for when I do:
Trade: ASHR ($41) Buy the Aug 36/ Sept 41 put calendar diagonal for $3
– Sell 1 August 36 put at .50
– Buy 1 Sept 41 put for 3.50
Rationale – This is a diagonal put calendar that costs $3 for a 5 wide spread. The good thing about it if the ASHR collapsed before August expiration you’d still make money (unlike a same strike calendar on the 41 line). The downside is it’s still expensive and in order for it to really work well we’d have to time it perfectly and hopefully have a move towards the short strike that could continue to be rolled out (and maybe even down).
We are also considering other strategies, but wanted to get our thoughts out there.