Shanghai shares dropped by 7% on Monday, threatening every market that opens as the sun moves across the globe.
But if you depend on the mainstream financial media to tell you why China crashed, you’ll be scratching your head for quite awhile.
The reality is that we’re just starting to see the results of a looming disaster I pointed to back on June 1.
Like a summer dust storm that darkens city skies and gets in the doors of even the fanciest hotels, China’s IPO onslaught is getting grit into every corner of the market.
As the summer closes, let’s look at what’s up and what’s down in China shares.
China’s IPO Onslaught is Shaking Global Markets
After an 8-month moratorium on IPOs, nearly three dozen public offerings were promised to hit the Shanghai and Shenzhen Chinese mainland shares over the summer.
Now, closing in on Labor Day here in the States, the Middle Kingdom’s IPO thaw has turned from a “welcome development” into a recurring “blow to the vulnerable stock market,” as the China Securities Journal reported late last week.
That metamorphosis is largely due to the quality of the shares now flooding the A-share market (A-shares are mainland shares with different restrictions than Hong Kong H-shares, which can be owned by foreigners).
Namely, the biggest IPOs we’re seeing are property developers. They hope to take advantage of government initiatives encouraging infrastructure and housing projects. Central planners say that roads and buildings — and specifically, roads to those buildings — will keep China above 8% GDP growth and lead its economy back into double-digit yearly expansion.
Yet “false prosperity” is now on the lips of many economists from Harbin down to Hong Kong. Echoes of Greenspan’s “irrational exuberance” now carry across the land, and Communist China’s cronyism means this train may go off the tracks before anyone can really slow it down.
No fewer than four major property developers have already listed their shares or are about to do so this summer: Gemdale Corp., China Merchants Property, Poly Real Estate Group, and now the nation’s #2 developer — China Vanke Company — are all using IPOs to reduce their debt-to-asset ratios and raise their public profile.
We know from the dot-com boom that although a group of college kids can list their lemonade stand on NASDAQ to make them feel good and even get a few million suckers to buy in, that flight of fancy won’t make them top-notch businessmen, and the move could even poison the broader market.
Back to the future and China today. . .
China is a country of connections. Guanxi, the balance of favor that permeates every aspect of personal and entrepreneurial life, means that companies are often created and people sometimes improve their wealth for who they shared drinks with or whose relative they are. Is mutual back-scratching unique to China? Not by a long shot.
But what is peculiar to China is that we have companies like China State Construction Engineering Corp. launching the world’s biggest IPO in a year. That state-owned enterprise (SOE) raised $7.3 billion in a July IPO that was barely reported by U.S. press.
The Shanghai A-share benchmark plummeted by 20% in just two weeks early in August, proving that IPO excitement created more nervousness than optimism for China-based investors.
So what does that mean for U.S.-based investors?
My Winning Downside Play on China’s IPO Frenzy
At the beginning of the summer, I told you that we would see more gains added to China’s corner of the spring-summer global market rally, followed by an IPO-fed drop right about now.
Sure enough, Morgan Stanley’s China A-share ETF (NYSE:CAF) went from top position to dead last in the recent six-month trend vs. the Dow and iShares FTSE/Xinhua China 25 fund (NYSE:FXI). Even the Dow now outperforms CAF, as you see in this chart:
If you shorted CAF as I suggested, you’ve done quite well in the past month.
The easier downside play that I recommended, however, was the inverse of FXI — the ProShares Ultra Short FTSE/Xinhua 25, listed as (NYSE:FXP).
Since the beginning of August, FXP has soared to outperform not only its inverse but also the Dow and CAF. FXP is up more than 11% over the one-month period while CAF is down 15%.
The smart money was against China over the past month, that’s for sure. . . Just check out FXP here in green:
I did get one thing wrong back in June when I said that by September, it would be time to buy back into CAF and FXI. I didn’t expect that so much of the IPO boom would be based on housing. As I pointed out last week, there is some stupefying logic leading people to think property markets in the U.S. are all better now, or at least on the road to recovery. It’s easy to take apart month-on-month numbers that the National Association of Realtors put out, but China is actually looking at year-on-year growth in housing market investment.
Read this sentence from the China Securities Journal well though: “Housing investment rose an annual 11.6% in the first seven months of the year.”
Not home prices, not access to finance for buyers — just housing investment. Dumb money pouring in from the top does not a recovery make.
China’s market jitters will last longer than anyone thought. Hedge any long index-based positions carefully, and consider doubling down on shorts or inverse ETF plays in your portfolio.
Regards,
Sam Hopkins
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