June 18, 2015

Chinese stocks worries Doug Kass

There's little question that Chinese stock prices have outstripped fundamentals. According to an excellent Economist report, median P/E on the Shanghai Composite is 75x.

After failing to reflate China's property market and in light of more signs of a slowing deceleration in domestic growth, Chinese authorities have turned their attention to inflating their stock market -- encouraging speculation in a host of ways. That includes liquidity injections through monetary easing, as well as urging people to reallocate assets into stocks and away from property, savings and wealth-management products.

Chinese brokerage accounts are growing exponentially in response, with 8 million new accounts in the first quarter alone, according to The Economist. Average daily trading volumes are also hitting new records.

With small "floats" and a system that's characterized by opacity, secrecy, corruption and limited regulation, many Chinese stocks have been pushed up to Space Balls' "Ludicrous Speed."

The Shenzhen Composite index has tripled over the last 12 months, and the Chinese averages have been climbing parabolically since March. (Here's a 12-month chart of the iShares China Large-Cap ETF  (FXI), which demonstrates China's relative and absolute outperformance.)

Daily market moves of +4% have now become routine, but numerous stock frauds of companies whose shares are up more than five-fold are being uncovered every week.

As The Economist found, one pet-food company trades at 220x earnings, while a sauna maker sells for 285x earnings and a manufacturer of fans goes for 730x earnings.

The magazine also reported that 100 Chinese companies have changed their names this year. A hotel company rebranded itself as a high-speed railway company, a fireworks manufacturer became a peer-to-peer lender and ceramics specialist became an energy company.

Kemian Wood Industry, a composite-floorboards manufacturer that faced a slump in its end markets, recently saw its share price briefly double after the firm changed its name and revised its focus to online gaming, according to The Economist. The magazine said China's state broadcaster recently accused the company of "fabricating themes and telling stories" in order to inflate its share price. (The firm denied the allegations.)

This week's potential disaster is Hanergy Group.

On CNBC two days ago, Muddy Waters' Carson Block raised concerns about Chinese stock frauds in China, calling this the largest "pump and dump in history."

What really shocks me is that many otherwise-sober observers have accepted the Chinese market's ramp-up as understandable and reasonable. One market watcher called it "a change in psychology," with share prices "moving from the lower left to the upper right."

Sometimes what's front of us is mistakenly accepted as normal even though it's absurd on so many bases. It's abundantly clear how inflated the Chinese bubble is.

As Credit Suisse put it: "(China's) equity market price momentum has decoupled away from earnings revisions which remain deeply embedded in negative territory."

I recently added the Chinese stock-market bubble to my list of 13 intermediate-term concerns.

Shorting FXI looks like a good move, but I don't have the stomach to do so and I certainly can't calibrate the timing of such as short. That said, I'm seriously looking at FXI puts.

When the bubble bursts -- and it will -- a long shadow will be cast over the Chinese economy, as leverage has played a crucial part of the rally.

Margin buying has increased more than five-fold in the last 12 months to over $325 billion, according to The Economist. Moreover, the magazine found that "umbrella trusts" (in which banks lend to wealthy investors) have added more debt to stock buying. The Economist said that Credit Suisse estimates nearly 10% of China's market capitalization is funded with credit -- nearly five times the developed world's average.

As David Clayton-Thomas once sang:

"What goes up, must come down."

VIA http://www.thestreet.com/story/13177647/2/wal-mart-apple-banks-china-stocks-doug-kass-views.html