May 11/15 – Everyone is too bearish on China

2015-05-11 2pm EDT  |  #Chanos #China #Druckenmiller

My best (and oldest) friend got married in September of 2009. Although there are a million things I remember from that event, I never thought it would include one of my most important trading lessons.

My buddy got married a lot later than me. We are the same age, but in our youth, while I was sitting on a trading desk uselessly banging back and forth whatever financial security could make me some money, he was busy working abroad, experiencing everything this new, rapidly opening up, global economy could offer. He took a job in China and learned Mandarin. During his time off, he travelled extensively and immersed himself in all the different cultures he could find. Then he decided to get his MBA. Most of my other friends would have come back to Canada and studied at Queens or Western, but not my best friend. He decided to get his degree from IMD(a school which I had never heard of, but most better-educated-than-I people know it as one of the top global MBA schools). From there, he got a job working for a big Swiss company and over the years, worked at many different locations throughout the world. When he finally came back to Canada to get married, his network of friends looked like a Benetton ad.

During the week-end of his wedding, I was exposed to a group of people who had literally just flown in from the countries I was speculating in. At the time, one of the countries that I was bearish on was China. This was the fall of 2009 and although the US had rallied a fair bit off the credit crisis lows, the financial community was firmly in the camp that any bounce in the US was temporary. But China, ahhh…. China. In 2009 they could do no wrong. The stimulus applied during the previous year’s global financial meltdown was hitting the streets and creating another Chinese boom. The government’s fiscal and monetary injections were going straight into the economy, creating a euphoric economic nirvana.

When I spoke to my buddy’s friends about the possibility the Chinese “economic miracle” might be a mirage, they looked at me like I had two heads. Who was this Canadian idiot whose idea of travelling the world is maybe visiting Paris and London for a week during the summer holidays? He obviously didn’t understand what was happening in China. He really should travel a little, and then maybe, just maybe he might understand the seismic shift the global economy is experiencing. I am making them sound a little mean, but they weren’t – they simply truly believed in the China boom. There was no denying they had all drunk the cool-aid, and wanted nothing to do with the ignorant trader who was suggesting that the purple juice might not be everything it was cracked up to be.

And it wasn’t just me that was experiencing this sort of “bash the China skeptics”. The famed short seller Jim Chanos absolutely nailed this trade, but for a longest time, the China “experts” tried to discredit him by pointing out he had never even visited China.

"Well, hell, I didn't work at Enron either." Jim Chanos (who smoked out the fraud at Enron) responding to criticism that he has bearish views on China without ever having visited the country.

When Jim produced figures that showed how much excess office space and housing were being built, the China bulls found ways to dismiss his arguments. Never mind it would take decades for demand to catch up with supply, didn’t Chanos understand the great migration from the rural communities to the urban ones? Chanos would try to reason that math is math, and that eventually this sort of pace could not be sustained, but the China bulls would have nothing to do with his logic.

It is hard to be in the minority. I know everyone likes to think they are a contrarian, but the simple fact of the matter is that by definition, not everyone can be a contrarian. It is a lonely and difficult place. Sitting outside the herd, listening to the taunts of being too stupid to understand how ridiculous you look, takes a huge strength of will.

And then, even if you are strong enough to fade the consensus, sticking with the trade is even harder. One of the first China skeptics I stumbled across was this cantankerous Scottish hedge fund manager named Hugh Hendry. His initial fame came from his YouTube videos documenting all the empty Chinese towers. Hugh was about as bearish on China as you get. As the China bull market continued (despite his repeated calls of bearishness), he became even more vocal in his warnings about the coming day of reckoning.

For the next year, the China bull market continued its steady climb. Then one day, instead of some great crash, the China “economic miracle” quietly died. It just rolled over, and has been steadily dripping lower ever since. At first few realized it. It was just a pause. But then the old China trades which had worked for so long, refused to get up off the mat. Since then, the China bulls have been strangely quiet.

You would think that Hugh Hendry would have been raking it in. After all, his long awaited China day of reckoning was finally unfolding. If we use VALE as a proxy for the “China bull trade,” you will notice that the top was January 2011.

Given Hendry’s bearishness, you would expect him to have performed terrifically from the beginning of 2011 to the present time. But when we bring up his fund’s performance, you will notice that this was a difficult time for him:

Even though Hugh was about as bearish on China as you could get, he still managed to mess up and not take any money out of the market. He only had the recent big performance uptick after proclaiming he was going to “take the blue pill” and climb on board the Western markets bull run. Like we learned last week with Bill Gross’ selling bund straddles, it is a lot easier to be right than to take money out of the markets.

So not only is it difficult to stand alone from the herd and not be swayed by the siren song of the masses, but then actually extracting money out of the market is just as difficult. The China slump was pretty easy to call, but the slow motion nature of the unwind has been extremely difficult to trade. I can’t claim any better success than Hugh for capitalizing on my China bearishness.

Heading the other way

Just as everyone was way too bullish on China in 2009, we have now entered the complete opposite situation. After four years of death by a thousand cuts, there is virtually no one that can imagine the Chinese economy performing well in the coming couple of years. The recent rise in the Chinese stock market is met with a derision that is usually reserved for telemarketing calls at home during dinner. I think that Stanley Druckenmiller’s bullishness is a lone voice in the wilderness. Everyone else is convinced that the Chinese government is stuck in a no-win situation where all liquidity will flow into a stock market (or real estate) bubble. They therefore reason that the Chinese economy is doomed to continue to underperform.

Last night the PBOC lowered their interest rate by 25 basis points. Instead of the market celebrating this move, the reaction was a muted meh. This Bloomberg story was typical of the lack of excitement.

Instead of being hopeful, the market is interpreting easings as a sign things might be even worse than realized. This Reuters report sums up the gloomy mood:

Economists had said it was not a matter of if, but when China eased policy again after economic growth in the first quarter cooled to 7 percent, the slowest pace since 2009.

Some market watchers had even said the central bank was risking falling behind the curve in responding to rapidly deteriorating conditions.

dInitial indicators and industry surveys for April released over the last few weeks had pointed to a further loss of momentum heading into the second quarter.

“Currently, the pace of domestic economic restructuring is quickening and the fluctuation of external demand is relatively big. China’s economy is still facing relatively big downward pressure,” the central bank said.

"This is not a surprise. The consumer inflation reading for April was lower than expected and employment faces downward pressures,” said Lin Hu, an economist at Guosen Securities in Beijing.

“But the effectiveness of the rate cut won't be very big, it may (only) help stabilize expectations. Fiscal policy should be stepped up and there will be further monetary policy easing if economic data continues to underwhelm. We expect the worst could be over after the second quarter and growth may stabilize in the third or fourth quarters as the property sector recovers."

I find it amusing at how ambivalent the market is treating the recent China moves. The Chinese stock market is running like it stole something. According to Druckenmiller that in itself should put you on the alert for improving economic conditions in the coming quarters.

But then, we also have a Central Bank that is also easing. Everything is pointing towards higher economic growth.

I know there are lots of negatives out there still. If it was perfectly clear, the markets would have priced it all in already. Yet I can’t help but think that odds favour Chinese (and most likely global) economic expansion in the coming quarters.

It is a lonely call, but isn’t that how it is supposed to be?

As for my buddy’s friends from the wedding, one of the most ardent China bulls got a new job in the US. And you will never guess where he is now working…. Actually I take that back, you will guess it all too easily…. Yup, you got it – Silicon Valley…. I wonder how bullish he is on late stage tech privates….