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.

 

 

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.

MSCI and China’s A shares

A few days ago, MSCI, the premiere authority on the structuring of stock market indices around the world, declared that it had been carefully considering adding Chinese A shares to its Emerging Market indices–and concluded that it would not yet do so.

What is this all about?

MSCI

MSCI (Morgan Stanley Capital International) creates indices that investment management companies use to construct their products–both index and actively managed– and to benchmark their performance.

Having a certain stock, or a set of stocks, in an index is a big deal.   For passive investors, it means that they must hold either the stocks themselves or an appropriate derivative.  Either way, client money flows into the issues.

For active investors, they’re forced to at least research the names and keep them on their radar.  If they don’t hold a certain stock or group, they’re at least tacitly betting that the names in question will underperform.

 

If we measure economic size using Purchasing Power Parity, China is the largest in the world.  It seems odd that the country not be fully represented in at least Emerging Markets indices.

 

China

Beijing, in the final analysis, would like to have international investors studying A shares deeply and buying and selling them freely.

How so?

In many ways, the story of the growth of the Chinese economy over the past three decades has been one of slow replacement of the central planning attitude of large, stodgy state-owned enterprises with the dynamism of more market based rivals.  The heavy lifting has been done by constant political struggle against powerful entrenched, backward-facing, political interests that even today control some state-owned enterprises.  It would be nice for a change to have the market do some of the work–by bidding up the stocks of firms that increase profits and punishing those that simply waste national resources.

 

In addition, Beijing now seems to believe that freer flow of investment capital in and out of China can act as a safety valve to counteract the extreme boom/bust tendency that the country’s domestic stock markets have exhibited in the past.

 

the burning issue?

Foreign access to the A share market is still too limited.

Fir some years, China has had a cumbersome apparatus that allows large foreign institutions to deposit specified (large) sums of money inside China and use the funds to buy and sell stocks.  But becoming a so-called qualified foreign institutional investor and operating within government-set constraints is a pain in the neck.  It’s never been a popular route.

Recently, Beijing has begun to allow investment money to flow more freely between Hong Kong and Shanghai.  A HK-Shenzen link is apparently also in the offing.

In MSCI’s view, this isn’t enough free flow yet.  I think that’s the right conclusion.  Nevertheless, weaving A shares into MSCI indices is only a question of time.

my thoughts

As professional securities analysts from the US and elsewhere turn their minds to A shares, there stand to be both big winning stocks and equally large losers.  The big stumbling block will be getting reliable information to use in sorting the market out.

Hong Kong back to earth

After four days of furious buying by mainland institutional equity investors, the Hong Kong market had a down day today.  This comes despite continuing healthy money inflow from the Shanghai-Hong Kong Stock Connect mechanism.  Although I didn’t watch the market closely (too late in the night for me), it seems as if sellers emerged in force in the afternoon when mainland money was unable to push the market much higher in the morning.

As one might expect, the big winners of the past week were the big losers of today.

Although I feel no overwhelming need to buy tomorrow, it looks to me that Stock Connect will end up setting a higher floor under China-related shares in Hong Kong than was possible when locals and US/EU international investors were the main participants in the market.

 

I’ve been a bit bemused at media surprise that many Hong Kong heavyweights have not participated in the rally.  The stocks in question have at least one of the following characteristics:

1.  they have broad global exposure but no particular focus on China,

2.  they’re controlled by UK interests and continue to be symbols of former colonial rule, and/or

3.  in the case of the “hongs” or trading companies, they are the 21st century form of the British-owned opium companies that were Hong Kong’s mainstay in the nineteenth century.  During the Opium Wars of the mid-1800s, Britain invaded China, forcing legalization of trade in the narcotic and effectively seized of Hong Kong Island and a chunk of the mainland from Beijing.  Companies strongly connected with this national humiliation are the last firms mainland investors are likely to buy!

What stocks are mainlanders buying?  They’re what one would expect:

–companies dually listed in Hong Kong and China, but trading at a discount in Hong Kong

–companies with attractive businesses in China, but listed only in Hong Kong.

Trading over the next few days will likely give us a better idea of the staying power and price sensitivity of mainland investors.  For me, the key question is whether Stock Connect buyers will let prices drift down before reentering.