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The brewing storm in Asia

Summary:
Preface: Explaining our market timing modelsWe maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade. The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”  My inner trader uses the trading component of the Trend Model to look for changes in the

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Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”
 

The brewing storm in Asia

My inner trader uses the trading component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. The turnover rate of the trading model is high, and it has varied between 150% to 200% per month.

Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
 

The brewing storm in Asia

The latest signals of each model are as follows:

  • Ultimate market timing model: Buy equities
  • Trend Model signal: Neutral
  • Trading model: Bearish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
 

Looking for the risk in the wrong places?

Waiting for China to report its Q3 GDP growth used to be not very suspenseful. Is it going to be 6.7%, which was the last report, or will they allow it to fall to 6.6%, which is the market expectation? As it turned out, Q3 GDP came in at 6.5%, which was below market expectations, and a possible signal of acute weakness in the Chinese economy.
 

The brewing storm in Asia

Notwithstanding the highly manipulated economic statistics coming from China, I have been monitoring the real-time signal of the China rebalancing theme using my long New (consumer) China ETF and short Old (finance and infrastructure) China ETF pairs for quite some time. The two pairs consist of long Invesco Golden Dragon China (PBJ) and short iShares China (FXI), and long Global X China Consumer ETF (CHIQ) and short Global X China Financial ETF (CHIQ). As the chart below shows, New (consumer) China has been dramatically underperforming Old (finance and infrastructure) China.
 

The brewing storm in Asia

To add insult to injury, Old China is also performing badly on an absolute basis. Last week, I outlined a number of disparate real-time bearish tripwires (see A correction, or the start of a bear market?). Most of the indicators focused on either US or global macro factors. One was the share of major Chinese property developers because property prices are sensitive barometers of financial stress, and rising financial stress would be especially important in light of the high degree of leverage in the Chinese financial system.

The share prices of Chinese property developers are weakening, and in some cases breaking down technically. When I focused on US indicators, I may have been looking for risk in all the wrong places.
 

Cracks appear in the China real estate

A recent FT article illustrates the high level of dependency that the Chinese economy has to real estate:

The property sector is estimated to account for 15 per cent of China’s gross domestic product, with the total rising closer to 30 percent if related industries are included. A downturn would add to financial strains on China’s heavily indebted property developers which paid record sums for land during auctions last year but are now struggling to recoup their investment.

Other evidence of a downturn is starting to emerge. Sales by floor area dropped 27 per cent year on year during the “golden week” national holiday earlier this month a peak period for house buying in China, according to research house CRIC, which tracks 31 cities.

Although average new home prices in China’s top 70 cities grew 1.4 per cent in August, the last month for which official figures are available, analysts say falling sales mean a period of price cuts has begun.

Since financial statement quality can be *ahem* dubious in China, lending is mainly based on asset value, and land constitute roughly 40% of collateral in total lending. If property developers were to cut prices, it would have an immediate effect on the health of the financial system. It was therefore no surprise that protests against price cuts have arisen across China:

A wave of protest by Chinese homeowners against falling property prices in several cities has raised fears of a downturns in the country’s real estate market, adding to pressure on Beijing to stimulate the economy.

Homeowners in Shanghai and other large cities took to the streets this month to demand refunds on their homes after property developers cut prices on new properties to stimulate sales.

In Shanghai, dozens of angry homeowners descended on the sales office of a complex that offered 25 per cent discounts to demand refunds, causing clashes that damaged the sales office, according to online reports that were quickly removed by censors. Similar protests have been reported in the large cities of Xiamen and Guiyang as well as several smaller cities.

As official statistics from China tend to be unreliable, I rely on indirect real-time market-based indicators for clues to the healthy of the economy. Here are the shares of China Evergrande Group (3333.HK), which is one of the largest property developers in China. The stock is resting at a key support level.
 

The brewing storm in Asia

Here is China Vanke (2202.HK), which is in a downtrend and broke a support level.
 

The brewing storm in Asia

The chart of Greentown China (3900.HK) looks downright ugly.
 

The brewing storm in Asia

Country Garden (2007.HK) also broke support and it is in freefall.
 

The brewing storm in Asia

You get the idea. The share prices of Chinese property developers have all broken support, with the exception of Evergrande, which is testing a key support level. All are in major or minor downtrends. They only recovered on Friday after the authorities verbally intervened, as reported by the Asian Nikkei Review:

Chinese financial regulators on Friday provided verbal support to ease unrest in the markets. People’s Bank of China Yi Gang said the central bank is studying some targeted measures to ease financing difficulties of companies. Guo Shuqing, chairman of the China Banking & Insurance Regulatory Commission, said separately that systemic financial risks were “totally controllable” and that the recent market turmoil is “seriously out of line” with economic fundamentals.

I am watching if the strong stocks like Evergrande (3333.HK) break support, or the weak stocks like Greentown (3900.HK) breaks its long-term support and test its 2011 or GFC lows. That will be a sign that the authorities have lost control and China’s economy is undergoing a disorderly unwind.
 

The brewing storm in Asia

A weakening economy

The softness in property prices is occurring against the backdrop of a weakening economy. Seven out of 10 of Fathom Consulting’s CMI 2.0 Indicators, which is an array of indicators that monitor the economy, are falling. Only one out of the 10 is rising, real exports, but the increase could be attributable to a surge from a “beat the tariffs” effect that is likely to be given back in the next few months.
 

The brewing storm in Asia

The Epoch Times reported that China Beige Book, which monitors the Chinese economy through a myriad of bottom-up sources, had some good news and bad news about China. The good news is Q3 was not as bad as it looks:

China Beige Book’s broader gauges of capital expenditure show that in the third quarter investment spending expanded faster in most sectors, not surprisingly led by key industries in the new economy.

Consumption trends are another area of misconception. Market watchers have been behind the curve on the state of Chinese retailing since at least May this year, when official retail sales growth fell to a 15-year low. More timely China Beige Book data show this weakness in official retail sales was primarily a lagged reflection of past softness, which we had reported during late 2017 and early 2018.

China Beige Book’s latest results show retail outperforming yet again, with sales, profits and hiring all improving. Recent official data have only very recently been playing catch up.

Lastly, the credit environment is also far more active than Beijing would have you believe. In spite of the government having yet to officially reverse its deleveraging policy, our data show corporate borrowing spiked in Q3, rocketing to the highest level since 2013.

The bad news is the systemic nature of the slump. Manufacturing is weak, and it is likely to become weaker. Moreover, the economy is not responding to the traditional stimulus tools:

What is most worrisome, then, is not the conventional story of Q3 weakness, but rather the opposite: that the economy is already seeing boosted levels of borrowing and investment and yet growth is weakening, nevertheless.

Like 2015, manufacturing is under fire, with earnings and profits weakening and orders getting crushed, especially on the export side. Notably this is occurring even before the more recent, larger round of Trump tariffs were imposed.

Moreover, cost pressures are increasing. Inventories are ramping up. And cash flow is suffering across the board, with the Q3 spike in late payments the worst we’ve picked up since late 2015.

In all of this we see alarming parallels with mid-2015, a period of heightened activity which presaged the China crisis of early 2016.

No PBOC rescue

Reuters reported that Beijing’s efforts to stimulate the private business sector with easier credit is not working. In central banker parlance, the transmission mechanism is broken:

Beijing is keen to show results after four rounds of policy easing, so China’s big banks are playing along, highlighting their efforts to boost lending to cash-starved small firms, offering collateral waivers and setting loan targets.

But in reality, banks’ loan eligibility requirements for small and medium-sized enterprises (SMEs) remain stringent, making it too difficult or too expensive for them to borrow, according to bankers and company executives.

That has forced some small firms, including exporters, to simply give up on borrowing and put investment plans on hold.

The health of millions of small firms, most privately owned, is crucial to China’s efforts to ward off a sharp slowdown and mass job losses while fighting a bitter trade war with the United States.

In the meantime, S&P recently warned that local government (LGFV) hidden debt could be “as high as Chinese renminbi (RMB) 30 trillion-RMB40 trillion (US$4.5 trillion-US$6.0 trillion)”.  The ratings agency expects that the central government will weaken support for LGFV debt over time, and more defaults are likely.

This time, the PBOC may be out of bullets. It is difficult to see how the central bank could ride to the rescue one more time by turning on the credit spigots when the economy is already over-leveraged, LGFV debt is out of control, and the SME transmission mechanism is broken. The PBOC has embarked on a program to slow the economy, and M2 money supply growth has been slowing. As the chart shows, M2 growth leads GDP growth by about a year, and the market has to be prepared for further growth deceleration.
 

Real M2 growth leads GDP growth by 1 year
The brewing storm in Asia

A China hard landing?

The WSJ recently posted the factors leading to the past recessions in G7 economies since 1960. Of the 111 factor occurrences, China is at high risk in 59, or 53%, of those instances, if you add in the potential of a currency war, as well as a trade war.
 

The brewing storm in Asia

We have heard these kinds of China scare stories before, but this amounts to a “this will not end well” story if there is no bearish trigger. The poor performance of over-leveraged Chinese property developers, which represent the canaries in the coalmine of an over-leveraged sector, could very well that trigger. Such a development has grave implications for China, and possibly for the prospects of the global economic and financial systems.

From a technical perspective, the monthly MACD sell signal flashed by global stocks is another bearish warning for investors.
 

The brewing storm in Asia

A storm is brewing in Asia, and investors should be de-risking their portfolios. If the share prices of the property developers were to break down to multi-year lows, it would be a signal to really batten down the hatches. These stocks represent real-time canaries in the coalmine of an over-leveraged sector. The global economy relies on major EM countries like China and India as sources of growth. A hard landing in China would have grave implications for the prospects of the global economic and financial systems.
 

The brewing storm in Asia

The week ahead

In the past week, the bottom-up fundamentals were strong, but the market did not respond to the good news. Q3 earnings season is under way, and the latest update from FactSet shows that both the EPS and sales beat rates were well above the historical averages. Moreover, Street analysts continued to revise earnings upwards, indicating positive fundamental momentum.
 

The brewing storm in Asia

Here is the bad news. While the market punished earnings misses, it did not reward beats. The market’s failure to respond to positive news is a bearish sign that investor psychology may become excessively bullish, and some adjustments to expectations need to be made.
 

The brewing storm in Asia

Bespoke also observed that the market was “selling the news”, as stocks that reported, regardless if the results were positive or negative, opened higher but closed lower on the day.
 

The brewing storm in Asia

The hourly chart shows that the S&P 500 broke down out of a rising trend line (dotted line) Thursday, and rallied up to test the falling trend line Friday. These are the hallmarks of a relief rally failure indicating that a likely test of the old lows is likely underway. Subscribers received email alerts when my inner trader was stopped out of his long positions Thursday, and his entry into an initial short position Friday when the market strengthened to test the falling trend line.
 

The brewing storm in Asia

The Fear and Greed Index stands at 14, which is in the sub-20 level where past bottoms have been made. However, low readings represent a bottoming condition and they are not immediate actionable buy signals.
 

The brewing storm in Asia

That said, the market is likely too far off. The normalized equity-only put/call ratio flashed a buy signal by reaching a panic extreme level and began to mean revert.
 

The brewing storm in Asia

As I pointed out in my last mid-week post (see Is there any more pop after the drop?)  sentiment has not panicked yet, as evidenced by the lack of a spike in bearish sentiment in the II survey, and the backdrop of greed that allows Wall Street banks to price an Uber IPO at $120 billion valuation, which is a 66% boost from its last financing. These conditions suggest that we need another flush before a durable bottom can be made.

Short-term breadth indicator readings from Index Indicators are consistent with past oversold-bounce-retest patterns seen in past bottoms.
 

The brewing storm in Asia

My inner investor has been increasingly cautious on equities since August. My inner trader tactically shorted the market in anticipation of a final panic selloff that marks the bottom of this pullback. He entered into a small initial short position Friday, but he is prepared to add to his shorts should the market strengthen early next week.

Disclosure: Long SPXU
 

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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