Betting against the “China Miracle”

Last week’s bounce notwithstanding, the major averages are still trading below their long-term moving averages. As long as that is the case, you should maintain a defensive stance in your Global Bull Market Alert portfolio. With all of your current positions related to global currencies — short the euro but long the yen and the U.S. dollar — that’s exactly where you are positioned.

This week’s Global Bull Market Alert recommendation is a bet on a continued weakness in emerging market stocks and, in particular, the weakest emerging market of all, China.

If global emerging markets have had a rough 2010, China has had it much rougher. The Shanghai Stock Exchange has lost 20.9% since the start of the year, putting it officially into bear-market territory. The market dropped over 9.7% in May alone — its worst monthly performance since September. Notwithstanding China’s strong growth rate of 11.9% in Q1, Shanghai is now the world’s worst-performing stock market in 2010 — just behind crisis-ridden Greece. 

I believe the downward trend in Chinese stocks has much further to go. The Shanghai Composite fell another 2.4% on Monday after China’s cabinet said it had approved a plan from the state planning agency to clamp down on a booming real estate market. A typical 1,000-square-foot apartment in Beijing now costs about 80 times the average annual income of the city’s residents, compared with historic levels of three or four times annual income.

Higher down-payment and mortgage rates have already started to let the air out of the Chinese bubble. Although real estate prices rose over 12% year on year across China through April, Bloomberg reports that property prices in the capital have slumped 31% just over the past one month alone. That is an astonishing collapse.

The property sub-index of the Shanghai Composite has already suffered a serious crash, slipping 28.5% since the start of the year and 46% since its July 2009 peak. But it’s China’s banking sector that is going to bear the brunt of the pain. Today, four out of the world’s top 10 banks are Chinese. Yet analysts estimate that Chinese banks can withstand a 30% to 40% decline in home prices before collapsing. With that drop already evident in Bejing, it’s only a matter of time before the collapse in real estate prices spreads throughout the country. And that spells big trouble for China’s banks.

Profiting from a bet against the Chinese stock market is tougher than it seems. Ideally, I would recommend that you sell the Claymore/AlphaShares China Real Estate (TAO). But there is very little volume in this ETF, and you may have trouble borrowing the ETF to short. And, on the face of it, the ProShares UltraShort FTSE/Xinhua China (FXP) would seem like the way to go. But bitter experience from the 2008 stock market crash in China has taught investors that short, leveraged ETFs — especially in volatile markets like China — do not deliver as advertised.

So, I am going to recommend that you short the unleveraged iShares FTSE/Xinhua China 25 Index (FXI) directly. I expect FXI’s 45% weighting in the large Chinese banks to weigh substantially on this ETF, as China’s real estate bubble collapses. With trading exceeding an average of 32-million shares a day, you should have little problem shorting this position. For online traders, highlight the words “sell short” when placing your order. Since this is a short position, and you profit when the price goes down, your stop price will be above its current level. So buy back the shares if the fund hits $45 to limit your losses.

If you are looking for potentially bigger gains, I’d recommend you buy relatively long-dated January 2011 $35 put options (FXI110122P00035000). With an eye-popping 105,000 options outstanding, you’ll certainly have plenty of company in this bet. Full disclosure: this is a position that I intend to take for my clients at my investment firm, Global Guru Capital.

Portfolio Update

UltraShort Euro ProShares (EUO) hit yet another record high of $25.29 on Wednesday, and ended the week 4.6% higher. With Spain downgraded at the end of the week by ratings agency Fitch, and talk of restructuring Greek debt growing, your bet against the European currency remains a BUY.

CurrencyShares Japanese Yen Trust (FXY) hit a high of $110.17 on Wednesday before pulling back to just under the $109 level. For all of Japan’s economic problems, the yen still remains a place where global investors escape when markets swoon. FXY remains a defensive BUY.

PowerShares DB US Dollar Index Bullish ETF (UUP) rose slightly over the week as the U.S. dollar maintains its strength in the face of global market volatility. UUP remains a defensive BUY.

P.S. If you want to keep up with my latest insights on developments in fast-paced global markets, you can now follow me on Twitter on @NickVardy or on my new blog, NickVardy.com.