October 24, 2015
Danger: This Market is
More Toxic Than Most Realize
By Jared Levy
Recently, I talked with two trusted friends who are traders based in China. One of these men, Naida, ran a hedge fund in Singapore and then moved it to China to be closer to his wife and take advantage of the rising need for good investment advice and futures trading skills in the mainland. The other is an old friend, Wu, who used to trade in New York with me back in the late 1990s and early 2000s. He's one of the smartest guys I know and an expert in quantitative algorithms.
Both lamented the hellacious market controls implemented by the Chinese government to calm volatility and stop the flow of money out of stocks. In the past few months, Chinese authorities have threatened to throw short sellers in jail and have instituted a 100x increase on day trading commissions and astronomical increases in margin costs.
They reaffirmed my concerns about the country's deteriorating fundamentals and mentioned that investors and banks had taken on extreme amounts of leverage. In short, according to the first-hand accounts of these gentlemen, the risks in China are much higher than the media lets on.
And they tell me it's only getting worse.
Over the past few months, Naida's once-thriving business has all but ground to a halt after China clamped down on short-term trading and installed dramatic regulations that make it nearly impossible for him to manage his operations. Most likely, he will end up relocating his family to Singapore and resume his trading there.
Wu is also feeling the pinch. Previously, he'd been extremely successful trading millions in futures and options. He even started managing money for wealthy clients in China a few years back. Now, much of his clients' free cash flow has slowed due to the debilitating government controls. Wu's looking for a backup plan in case things get bad in China and is interested in learning more about a possible joint venture with me here in the United States.
The two of them are extremely bright, wealthy and plugged into the complex Asian markets. Both see a somewhat hard landing for China's economy.
Even though there are warnings everywhere, it seems the majority of investors believe China is doing much better than it really is.
After these meetings, I was motivated to take another look at China's predicament. By my estimates, investors still have a relatively optimistic view despite the country's volatile markets and slowing growth. This is because China's government has done a good job of controlling the information that enters and exits the country. But like some of the greatest manipulators in history have shown us, you can't hide forever.
Here's what we do know:
1. Government meddling has propped up China's stock market.
According to Goldman Sachs (NYSE: GS), the country has dropped $236 billion (USD) on the Chinese stock market since the middle of June 2015. This spending came alongside five interest rate cuts in just nine months.
2. Even as the Chinese stock market has stabilized, economic data continues to deteriorate.
I recently detailed a number of these issues for my Profit Amplifier subscribers, but in a nutshell, conditions are negative across the board.
-- In August, factory output grew by 6.1%, below already slashed estimates for 6.4%.
-- Fixed-asset investments, such as homes, slowed to just 10.9% year to date, a 15-year low.
-- China's also experiencing falling car sales, growing inflation, slowing imports and a 25-year low in GDP growth estimates.
Bottom line: I don't see a light at the end of the tunnel yet.
3. The Chinese yuan is being devalued.
China's yuan has been on the decline against the U.S. dollar and other currencies for some time. Last month, the country's central bank unexpectedly dropped the value of the yuan by 2%, triggering a bit of panic among experts.
In simple terms, China is caught in a downward spiral where its solutions spark bigger problems elsewhere that will eventually come back to hurt China again.
Chinese Stocks Still Look Overvalued
Despite a number of negative factors, China's stock market is still up about 40% in the past 12 months. Based on everything we already know about the country's economy, that optimism seems completely unfounded.
There are several other reasons why I think China is in much worse shape than we've been led to believe. I don't have time to detail them all in today's essay, but suffice it to say that I see a lot of parallels between what's going on with China today and the 2008 crash in U.S. markets.
As we continue to learn just how bad things are in China, I believe we'll see that optimism deteriorate. The government's assurance is the only thing supporting China's stock market, which isn't a good long-term solution.
Back in July, my Profit Amplifier readers and I used the iShares China Large-Cap ETF (NYSE: FXI) to profit from weakness in Chinese markets. But rather than simply shorting this fund, we used put options to earn a 39% return in seven days -- that's 2,036% annualized -- risking just $525.
That's the beauty of options. They're one of the most effective and least risky ways to capitalize on a plummeting stock or ETF in a short amount of time.
I think conditions are ripe for a similar trade in FXI. When I find the right option, I will immediately send an alert to my Profit Amplifier readers. To find out how you can get on the list to receive my trades, follow this link.
If you'd like a full rundown on how options work and how I use then to make1,000%-plus annualized profits from downside moves in stocks, then I encourage you to check out this presentation.
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