Shenzhen Connect starts next week

…on December 5th.

That’s according to the Hong Kong Exchanges and Clearing Limited (HKEX), whose Stock Exchange of Hong Kong subsidiary signed an agreement with its Shenzhen counterpart on rules for Shenzhen Connect last month.  The agreement was just approved by mainland Chinese regulators.

what is Shenzhen Connect?

It’s a mechanism that allows investors in Hong Kong to buy or sell Shenzhen-listed stocks, up to a specified (but large) total daily limit.  It also allows China-based investors to buy and sell Hong Kong-listed stocks through the Shenzhen Exchange.

The start of Shenzhen Connect trading follows the successful establishment of a similar arrangement between Hong Kong and Shanghai, called Stock Connect, a little more than two years ago.

significance?

In a practical sense, Shenzhen Connect and Stock Connect together end the closed nature of the Chinese stock market.  Doing so is an important economic objective of Beijing.  It’s another step down the road to dismantling the central planning and control that has characterized Chinese socialism since WWII.

rising Shenzhen shares?

Will this signal a boom in Hong Kong interest in China-listed shares?  I don’t think so, but it will be interesting to watch and find out.

Stock Connect, which opened the Shanghai stock market to foreigners wasn’t such a big deal, in my view.  That exchange is dominated by state-controlled banks and by stodgy old industrials headed mostly by state functionaries with no idea of how to run a profitable business.  Beijing will protect the banks but is content to let the  gradually wither and die.  So I didn’t see any rush to be the first foreigner to arrive in 2014.

The Shenzhen Exchange, on the other hand, is home to much more entrepreneurial firms, with little or no official state involvement.  So, in theory, yes, I might want to participate.

A big roadblock for me, though:  I have no idea whether I can trust the financial reports that companies issue.

Two ways to find out: listen carefully to what local players say and do; and visit the companies that sound interesting, interview the managements–and then watch to see how what they say matches up with operating results and what the financials report.

Even then, my experience is that you may not be safe.  Years ago, I visited a small Hong Kong manufacturing company at the urging (I didn’t need much) of a friend.  The firm told me a fabulous story of its success making computers for children.  I went back to see the management some months later.  They didn’t recognize me as a person they’d spoken with before.  This time they told me an equally dollar-sign-filled story, but this time they were an auto parts firm.  Whoops.

I’m not willing/able to put in the effort required to understand how the stock market game is played in Shenzhen.  So, Shenzhen Connect won’t tempt me away from the sidelines.

 

 

thinking about China: economic growth and metals

In the late 1970s, Beijing decided that its central planning model of economic development wasn’t working because the domestic economy had become too complex.  It reluctantly shifted to the model Japan had used to recover from WWII–concentrating on export-oriented manufacturing, offering cheap labor in exchange for technology and industrial craft skill transfer.  China became an increasingly large user of natural resources (oil and metals) as it created industrial infrastructure, industrial plants and provided housing and other public services for its large population.

Maybe ten years ago China realized that it was soon going to run out of low-wage farm workers willing/able to switch to manufacturing in order to sustain the export-oriented model.  Associated pollution and other environmental problems were also becoming more acute.  So the natural resource intensive, export path to growth was nearing an end.

Five years or so ago, China, now out of cheap labor, began the shift to a consumer-oriented, domestic demand approach to GDP growth.  Government stimulus to offset the negative effects of the recent recession gave exporters one final surge of vitality.  Still, for years manual labor-intensive businesses have been leaving China for, say, Vietnam or Bangladesh.  Beijing has also been cracking down on relatively primitive steel and aluminum processing operations.

Politically and socially, as well as economically, this is a difficult transition to make, because rich and powerful forces of the status quo don’t want things to change.  Japan, Singapore and Hong Kong (multiple times) have made the shift; Malaysia, Thailand and much of South America have not.

One of the main characteristics of this period of change is a slowdown in demand for base metals and other industrial inputs.  For China, which had been the dominant customer for almost any base metal, the transition comes just as global mining companies have made (inexplicably, to my mind) huge additions to productive capacity.

The result of increasing supply at a time of flagging demand is easily predictable–lower prices.

Why write about this?

Many financial markets commentators have been pointing to low base metals prices as evidence of cyclical economic weakness in China.  That may ultimately turn out to be the case.  But it’s equally a sign of:  1) structural change in the Chinese economy, which would be a good thing, and 2) witless mining companies.  So it’s by no means a sure thing that bears on China are correct.

By the way, the last global collapse in base metals prices came in the early 1980s.  That followed a decade-long period of mine expansion that was based on the idea that the United States couldn’t grow economically without using copper, lead, zinc and iron in amounts that would increase in a straight line with GDP expansion.  In hindsight, what a mistake!  Although Peter Drucker had been writing about knowledge workers from the 1950s, no one put two and two together.  It took almost two decades for world growth to absorb the excess capacity that miners added back then.

 

how one China-related ETF has fared

Yesterday I mentioned a Factset article about the trading behavior of China-related ETFs during the current market gyrations in Shanghai and Shenzhen.  It focuses on the Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS).  Quite a mouthful.

ASHS opened for business last year and has about $41 million in assets.  Its goal is to track the performance of 500 Chinese small caps.  It holds all of the names in the appropriate proportions, to the extent that it can.  Where it can’t, it finds the best proxies available.

Year to date through yesterday, ASHS has risen by 37%+.

The fund melted up in mid-June, however.  Its price rose by 40% from June 8th through June 10th alone, at which time it had y-t-d performance of +113%.

The bottom fell out in the following month, when ASHS lost slightly more than half its value–before bouncing back up by +30% over the past few weeks.

Two points about ASHS:

1.  The fund uses fair value pricing, which is the industry norm in the US.  Fair value pricing, usually performed by a third party the fund hires, does two things:

—-it adjusts the prices of foreign securities in markets that are closed during New York trading for information that has come to light after their last trade, and

—-it gives an estimate for the value of securities that are not trading for one reason or another on a given day.

(Note: in my experience, both types of adjustment are surprisingly reliable.)

This second feature has doubtless come in handy over the past couple of months, since there have been days when as many as half of the Chinese small caps haven’t traded.

 

2.  A mutual fund transacts once a day, through the management company, after the market close and at Net Asset Value.

In contrast, an ETF like ASHS trades continuously during the day, through a number of broker dealers (Authorized Participants), and not necessarily at NAV.

The idea is that these middlemen will use the very cheap brokerage record systems for fund transactions, thus keeping administrative costs down–and that the brokers will use their market making and inventory capability as a way of minimizing the daily flows in and out of the ETF portfolio.

In June, this worked out in an interesting, and ultimately stabilizing way for ASHS.

As I mentioned above, the market price of ASHS rose by 40% over two days in mid-June.  We know that, according to Chinese trading rules, the stocks in the portfolio itself could rise in value by at most 10% daily, or 21% over two days.  I can’t imagine the ASHS fair value pricing service decided that the portfolio was actually worth 40% more than two days earlier when the market signal was twenty-ish.  If I’m correct, the broker dealers decided to meet (presumably large) demand for ASHS shares by letting the premium to NAV expand substantially  …by 20%?…thereby choking some of the demand off, rather than issue a ton of new ASHS shares at a lower price.

According to Factset, the brokers did create new shares.  But they apparently lent at least some of them to short sellers, who sold them in the market, further tamping down demand.

So the Authorized Participants performed their market-making function admirably–presumably making a boatload of money in the process.   But this situation illustrates that the worst fears of possible ETF illiquidity in crisis times may be overblown.

 

 

 

 

 

Chinese stocks—and related ETFs

I got home late last night and flipped on the TV to watch baseball.  What came on first was Bloomberg TV, where reporters in London (?) and Hong Kong were exchanging near-hysterical comments about the declining Shanghai and Shenzhen stock markets.

The facts couldn’t have been much more at odds with their dire pronouncements.  Yes, the markets were down by 2% – 3%.  Yes, a small number of stocks were limit down.  But the markets were relatively stable and trading was orderly.  Given, however, that the main concern for global investors, as well as Chinese participants in the domestic stock markets, is to have China shrink the still-large amount of margin debt outstanding without a market collapse, overnight market action in Shanghai and Shenzhen  was a very positive development.  As it turns out, although the markets closed down slightly for the day, they were even up at one point.  Volumes were reasonable, too.  Let’s hope this continues.

(An aside:  the Bloomberg TV spectacle I witnessed is one more illustration, if anyone needed it, that the recent shakeup of the Bloomberg news organization is taking it further down the road toward infotainment and away from analysis.)

 

I came across a Factset article this morning discussing the performance of ETFs that specialize in small-cap Chinese stocks.  These have been the center of speculative activity in China over the past year.  But they have also been an area subject at times to protracted trading suspensions for some stocks and to days where some have been limit-up or limit-down with no trade.  The short story is that thanks to fair value pricing the ETFs themselves have experienced no problems.  More on this tomorrow.

three weird things that happened this week

1.  Greece  After months of vitriolic negotiations and after calling a referendum in which it successfully campaigned to have Greece vote against accepting a financial bailout from the EU/IMF, the Greek government appears today to have accepted that bailout.

2.  Chinese stocks  After plunging for a month, Chinese stocks have risen by 10% over the past two trading days.  The world is breathing a sigh of relief.  I’m not sure what’s weirder–that this happened or that foreigners believed for a short while that in a country where doing anti-social stuff can get you either a long prison term or beheading, rather than the cover of Forbes, China would be unable to achieve this outcome.  Actually, the foreign belief is way weirder.

3.  Microsoft/Nokia  Less than fifteen months after acquiring the cellphones business of Nokia, MSFT has discovered that what it bought for over $7 billion (led by mastermind Steve Ballmer) is essentially worthless and is writing off virtually the entire purchase price.  The stock went up on the news.

Which is weirder:  that the MSFT board that rubber-stamped this disaster is still intact?  …or that people are still buying Clippers season tickets?   I suppose you could argue that Nokia was the price for getting rid of Ballmer, which would imply that the behavior of Clippers fans is weirder.

(a little) more on the Chinese margin crisis

Chinese stocks closed lower by about 5% overnight, as the margin selling spiral continues downward.

My thoughts:

–this very strongly suggests that some margin accounts that have enough equity in them a day ago are under water now.  So Shanghai and Shenzhen will likely open tonight to more selling.

–to be clear, I don’t know exactly how Chinese margin works.  And, because I have no intention of buying A shares, I have no desire to find out.  A logical step for authorities to stop forced selling would be to loosen margin collateral requirements.  It may be, however, that the government has decided that the best course is to wring speculation out of the market as quickly as possible.  In other words, despite its rhetoric, it’s content to see the selling play itself out fully.

–margin players tend to be their own worst enemies.  Taking both their margin and cash accounts into consideration, they tend to have a mishmash of high quality stocks and speculative junk.  Their margin accounts tend to be heavily weighted toward trash.  The junk is what’s most vulnerable to price declines, since it has little, if any, intrinsic merit.  The logical response to a margin call is to sell the trash and keep the quality names.  Margin players, in my experience, invariably do the opposite.  They sell their winners and keep their losers, exposing themselves to continuing margin calls and prolonging the overall market agony beyond what it should be.

–I’m still guessing that the current selling will exhaust itself within two weeks.

the Chinese stock market now

declining stocks

Until about a month ago, Chinese stocks were soaring.  Over the prior year the main indices in both Shanghai and Shenzhen were up by about 150%.

Since then, however, both markets have been in a continuous tailspin, dropping a quarter of their value.

Beijing has just announced emergency stock market stabilization measures aimed at halting the fall, on the idea that swooning stocks will hurt capital formation (duh!) and clip a percentage point or more from economic growth–at a time when China doesn’t have that many points to spare.

What’s going on?

As part of its plan to gradually modernize its equity markets and ultimately open them to the outside world, China introduced margin trading (as well as stock index futures and short-selling) domestically in 2010.  China is now going through what all emerging markets eventually do–its first full-blown margin trading crisis.

margin trading

There are lots of ins and outs to margin trading, but it’s basically using the stocks you own as collateral for loans to buy more shares.  It can be very seductive when stocks are going up.  And it’s immensely profitable for brokers.  So it’s not surprising that margin loans are easily available to lots of customers.  Also, in many emerging markets, China included, it’s relatively easy to circumvent restrictions on margin lending by arranging bank loans collateralized by stocks that may not technically be margin borrowing, but effectively are the same thing.

The key aspect of margin trading is that the value of the securities in the account must exceed the margin loan total by a certain safety amount.  If prices fall to the extent that the safety amount shrinks, or is wiped out, the broker has the right to sell enough securities from the account to restore it.  He may call the client and give him the opportunity to add more money to the account   …or he may just sell.

However, this selling itself depresses prices further–eroding the value of the remaining securities in the account as well as any safety amount that may be built up.

Also, margin traders around the world tend to be both the ultimate dumb money and the ultimate herd animals.  They all but the same speculative stocks and they (almost) all leverage themselves to the eyeballs. Even if customer A is initially in fine shape, the selling in the accounts of customers B,C and D will pressure the margin balance of A as well as their own.

The first selling, then, tends to create an accelerating cascade of more selling that’s extremely hard to stop.

This is what China is experiencing now.  This is also why the government has stepped in with a massive market support operation to try to staunch the flow.

effect on the rest of the world?   …especially you and me

The Stock Connect linking mechanism between Shanghai and Hong Kong–aimed a diverting funds away from soaring mainland stocks–is now exporting the mainland weakness in much milder form to the Hang Seng.

Beijing has a ton of money and its stock markets are, realistically speaking, still not very open to the outside world.  As the current anticorruption campaign shows, the CCP has lots of ways to punish people who do stuff it doesn’t want.  So I imagine that the government will stop the downward stock market momentum.  The big questions are:

–how long will it take, and

–how large an unwanted portfolio of stocks (which will act as an overhang on the market) will Beijing have to purchase in order to achieve the stabilization it wants.

My answers are:

–I don’t know, but probably not more than a couple of weeks, and

–I don’t care, because I think the way to play a potential rebound from oversold levels is through the Hong Kong stocks now being sold by mainlanders.