The Participant 7/29/15: China

by Jason Kelly

Wednesday, July 29, 2015



The Shanghai Composite recorded its largest single-session crash since June 2007 on Monday, dropping 8.5% to 3726. A soft manufacturing report confirmed suspicions that the government’s recent attempts to reignite share prices were doomed to fail.

Former US Treasury Secretary and Goldman Sachs CEO Henry Paulson wrote in the Financial Times on July 21 that China’s capital markets have lagged the growth and maturation of its economy. He thinks that rather than rushing in to prop prices back up, China should use the stock market crash as an excuse to modernize its rickety financial system. Little surprise that Paulson’s prescription is for China to open its market to “a wide range of participants, including top-notch foreign institutional investors, investment banks and brokers, to compete on equal footing.” With no touch of irony, he suggests Beijing protect investors through regulation designed to minimize accounting fraud and market manipulation. His knowledge of the subjects runs deep.

Back on Shanghai’s descending price line, analysts offer conflicting advice from familiar camps. The bulls say this is a dip to buy, albeit one that could become deeper in the near term. The bears say this collapse is just getting started, but could exhibit knee-jerk rallies along the way because even unsustainable and misguided stimulus can work wonders for a while.

From the bearish camp, David Cui at Bank of America Merrill Lynch warns that China’s stock market looks a lot like America’s did in 1929. The parallel involves both going through an initial selling phase, followed by a stabilization phase, then another selling phase when authorities give up supporting prices and investors capitulate. Both bear markets sport repeating themes of too much leverage driving valuations to the moon such that no fundamental performance can sustain them.

Another problem is the profile of Chinese “investors” driving the market, who upon closer examination look like kids more than capitalists. An early awareness of this red flag spared onlookers from joining the fray back in spring. From Kelly Letter Note 13 sent to subscribers on April 5:

“Consider that the number of new trading accounts has exploded since China’s bull market took off last summer, reaching a five-year high in early March, and — this is the kicker — two-thirds of new accounts in the past quarter were opened by people who haven’t graduated from high school. Bloomberg economist Tom Orlik said, ‘The significance of the relatively low education level of new investors, I think, is that it suggests relatively inexperienced retail investors are driving the rally. That underlines concerns that it’s a rally divorced from the fundamentals of profit and growth, and so prone to a sudden reversal.'”

The Economist updated this angle on its Free Exchange blog two days ago: “It is not China’s grizzled stock pickers but rather their inexperienced grandchildren who have been the much bigger force in the market’s wild ride of the past year. … In 2004, 27.8% of those with stock-trading accounts were under the age of 30, according to the stock market regulator. This rose to 36.1% by 2013. … In the first quarter of 2015 (figures for the second quarter have not been published), 62% of a record 8m new trading accounts were opened by people born after 1980.”

The magazine quotes a 25-year-old video editor who invested her entire savings “only to watch her stocks halve in value in June and July.” She’s decided to sit back and wait for her stocks to rebound, saying it will be as if she’d left the money in her bank account — and she’s ready to wait for years.



From this year’s Note 26 sent to subscribers last Sunday morning, with data as of Friday, July 24:

West Texas Intermediate crude is in an official new bear market, having dropped more than 20% since June 10 to $48 per barrel. The global glut is expanding as US production hovers at 40-year highs, Saudi Arabian and Iraqi output are at record levels, and Iran is gearing up to start exporting again. US exploration and production (E&P) companies are reporting new ways to reduce costs, and hint that new growth lies ahead. This suggests the glut will continue, not abate.

Morgan Stanley is beside itself, saying last week that the worst-case scenario is unfolding before our eyes. In January, it said the crash would be as bad as the one in 1986, but no worse. Last week, it said it had anticipated OPEC would not cut its output, but “we didn’t foresee such a sharp increase. In our view, this is the main reason why the rebalancing of oil markets has not gained momentum.” Now, its projections see little recovery in the years ahead, compounded by an industrial slowdown worse than the one of 1986. If the current oil crash exceeds the one of 1986, it will become the worst in 45 years and have no precedent among data that analysts can study.

Morgan’s Martijn Rats wrote: “If this were to be the case, there would be nothing in our experience that would be a guide to the next phases of this cycle, especially over the relatively near term. In fact, there may be nothing in analyzable history.”

The price of US oil is back under $50 per barrel. West Texas Intermediate closed Friday at $48.14, down 5.4% for the week. Our oil-price hedge, PowerShares Oil -2x (DTO $91.08), rose 7.6%.

Facebook’s (FB $97) market capitalization overtook that of General Electric (GE $26) last week. A 24% rise in the social networking company’s stock this year has assigned it a market value of $272B, more than GE’s $259B. This strikes some as distorted, considering that GE’s sales totaled $147B last year when it employed more than 300,000 people, while FB’s sales totaled $13B when it employed fewer than 10,000 people. Facebook does boast more friends, however, which could explain the discrepancy.

Jeremy Grantham at GMO said during his keynote speech at the 2015 Morningstar Investment Conference that the stock market is edging toward bubble territory but isn’t there quite yet. … He concedes broad overvaluation by itself has never been enough to trigger a crash. He pegs next year’s presidential election as the time to get careful. “The market will follow the line of least resistance from the Fed, plodding slowly and steadily higher, waiting for speculation from individuals and deals. Be prudent, of course. Be very prudent … but not yet. I’m waiting to be very, very prudent. I’m going to be incredibly prudent starting closer to the election. I recommend the same to you.”

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Tom DeMark’s first contribution to The Z-val Zone appeared this week, via Bloomberg.

Chinese stocks will decline by an additional 14% over the next three weeks as the market demonstrates a trading pattern that mimics that of the US crash in 1929, according to DeMark, who predicted the bottom of the Shanghai Composite Index in 2013.

The benchmark for mainland stocks will sink to 3,200 after plunging 8.5% Monday to 3725.56 in the worst selloff in eight years, DeMark said on Monday. …

The Shanghai gauge had rebounded 16% from its July 8 low through Friday as officials went to extreme lengths to support stocks. … China Securities Finance hasn’t pulled support for equities and the government will “continue efforts to stabilize market and investor sentiment,” China Securities Regulatory Commission spokesman Zhang Xiaojun said in a statement after the close of trading Monday. …

“The die has been cast,” DeMark … said by phone. “You just cannot manipulate the market. Fundamentals dictate markets. … Markets bottom on bad news, not good news. You want to have the last seller sell. We got good news at the recent low. The rally is artificial. … Lip service and intervention like that — it’s false. There’s a certain way in which the market unfolds. The only thing the government could do is to postpone it.”

I characterized the disposition of this call as “Immediate-Term Bearish” for the Shanghai Composite, and scheduled it to be judged on August 17.

To see this call in The Z-val Zone, please visit:

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Background: The term “z-val” is a shorthand introduced in my book, “The 3% Signal,” for “zero-validity forecasters” and “zero-validity environment.” The latter phrase was coined by Nobel Prize winner Daniel Kahneman in his book, “Thinking, Fast and Slow,” where he wrote that “stock pickers and political scientists who make long-term forecasts operate in a zero-validity environment. Their failures reflect the basic unpredictability of the events that they try to forecast.” This is why stock market forecasters are proven to sport an accuracy rate of about 50%, same as a coin toss, yet they continue forecasting.

You can peruse the growing collection of tracked forecasts in The Z-val Zone at:

Know a good one I missed? Send me the link.



According to Jim Holt at New York magazine, they don’t make ’em like William Buckley and Gore Vidal anymore. In 1968, the two “celebrity intellectuals” were in their early 40s and “nationally famous in a way that no intellectual is today.”

They were both “patrician in manner, glamorous in aura, irregularly handsome, self-besottedly narcissistic, ornate in vocabulary, casually erudite, irrepressibly witty, highly telegenic, and by all accounts great fun to be around. … Also, they warmly hated each other.”

In that presidential-election year, they engaged in a series of ten nightly clashes on ABC that progressed “from stylish vituperation to arch bitchiness to near fisticuffs, culminating in an explosive exchange between the two combatants that left network executives and viewers at home not quite able to believe what they had heard: Vidal calling Buckley a ‘pro- or crypto-Nazi’ and Buckley calling Vidal a ‘queer’ and threatening to ‘sock’ him ‘in the goddamn face.’ Such language on television was unprecedented. As Dick Cavett later commented: ‘The network nearly shat.'”

Full article at:

Explosive exchange (73 seconds) at:

Be well and enjoy the rest of the week. Kelly Letter subscribers, see you Sunday!

Yours very truly,
Jason Kelly

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