How to fend off the Wolves of Wall Street

As the movie, The Wolf of Wall Street, opens, the NY Post recently featured an interview with Josh Shapiro, someone who worked for Jordan Belfort, the main character in the film, and the bait and switch tactics of the firm:

You got on the phone and pushed a stock that people know, say, Dr. Pepper. But then you said, “Really, it’s my IPOs — that’s where I’m going to make you the most money.” You got the account, and then you started selling them on our IPOs — very enticing initially, but if you bought, you lost. There was no way to win.

We used to joke that they used to get a couple of bums off the street, throw them in the shower, put a suit and tie on them, and say, “Listen, buddy, for the next couple of hours, you’re the president of Czech Industries.”

When a stock collapsed, the mentality was that even if you lost thousands of dollars you’d buy more — instead of relating to a client that it crashed, you’d say it’s trading at a discount. And it worked because everyone wanted to make money.

One criticism from early reviews of the film was that it seem to idolize the fast-cars-fast-women bacchanalian lifestyle of Belfort and ignored the victims of Belfort's scams. Here is one example from the New York Times Dealbook:

Left untold is the story of the victims, disparaged as “garbage” by Mr. DiCaprio’s character in the movie.

For many of them — small-business owners and people like Steve Orton, a State Farm insurance agent from Alpharetta, Ga. — the publicity for the movie has brought back the old pain. Still, Mr. Orton said, while “it kind of sickens me, I really feel like I owe it to myself to complete the circle to see it.”

Ken Minor, a real estate appraiser in Gilroy, Calif., said the experience “hurt me pretty bad.” He drew on a home equity line of credit to buy stocks with Mr. Belfort’s brokerage firm, Stratton Oakmont, and still has not repaid it. “I’m not a rich guy,” he said, “and I’ve been paying for it ever since.”

How to fend off scam artists
How ironic that the Wolf of Wall Street opens for broad release on Christmas Day, which is more culturally attuned to sharing with family and with the spirit of giving. Perhaps it was intended more as a celebration of Saturnalia, which was a Roman festival held in mid/late December that featured wild partying and the abandonment of everyday decorum, as per this account from Wikipedia:

Seneca looked forward to the holiday, if somewhat tentatively, in a letter to a friend:

It is now the month of December, when the greatest part of the city is in a bustle. Loose reins are given to public dissipation; everywhere you may hear the sound of great preparations, as if there were some real difference between the days devoted to Saturn and those for transacting business. … Were you here, I would willingly confer with you as to the plan of our conduct; whether we should eve in our usual way, or, to avoid singularity, both take a better supper and throw off the toga.

The more important takeawy for investors is to take the proper steps to avoid the scam artists that still prowl Wall Street looking for marks. Part of the problem was that investors didn't know what they were doing, or they were just looking to gamble with their savings, which was Josh Shapiro's belief, as he stated in the NY Post interview [emphasis added]:

But these were not grandmothers we were calling on the phone. These were qualified investors, who had, basically, a gambling habit. In my mind, I just can’t imagine how some guy in Texas that’s never seen me, that’s never met me can send me $50,000. I just don’t understand how.

To avoid these pitfalls, I have three suggestions:

• Look for investment advisors who adhere to the fiduciary standard;
• Use the 5Ps of investment manager selection; and
• Make sure you have an investment plan.

Fiduciary duty vs. suitability standard
The first line of defense against investment scam artists is to ensure that your investment advisor adheres to the more onerous fiduciary standard, rather than the looser suitability standard. Here is the key difference between the two. When an investor creates an investment portfolio, he has two key decisions to make:

1. What to buy?
2. How much to buy?

The fiduciary generally has to consider both questions and the investor usually gives the advisor the authority to buy and sell on his behalf. The advisor with the suitability standard only has to think about the first one and has to consult with the investor, who then gives the advisor the trade order. Moreover, the advisor who is a fiduciary is subject to personal liability for the well-being of the investor should he act in an imprudent manner.

Supposing that there is a highly speculative investment with high profit potential. An advisor subject to a suitability standard can call up virtually anyone and pitch the idea, because as long as it might has a place in the investor's portfolio, e.g. 0.5%, he is not breaking any laws or regulations.

5Ps of investment manager selection
Another way of weeding out the pretenders is the manager selection process used by many institutions to select investment managers. To illustrate, I wrote the following to someone who tried to solicit me as a client for their investment advisory business:

The principal process used by many institutions to select managers consist of the 5Ps:

People: Who are they?
Performance: Interesting but less relevant as past performance is not reflective of future returns
Philosophy: Do you have an edge on the market? If so, what is it?
Process: How do you implement your "edge"?
Portfolio: Does the portfolio reflect the principles outlined in the philosophy and process statements?

As part of my evaluation process of your group, please outline your investment philosophy and process.

The 5Ps framework is a great template for evaluating advisors. Investors can to use their own judgement as to the biographies of the people, their investment philosophy and process make sense and fit with their needs and comfort zones. Reputable professional managers who have a well-defined process should have no trouble answering such questions. As for the less scrupulous, well...


Know where you want to go
Finally, take some responsibility for your money and know your investment objectives. Remember the Alice in Wonderland passage of Alice's conversation with the Cheshire Cat?

"Would you tell me, please, which way I ought to go from here?"
"That depends a good deal on where you want to get to," said the Cat.
"I don’t much care where--" said Alice.
"Then it doesn’t matter which way you go," said the Cat.
"--so long as I get SOMEWHERE," Alice added as an explanation.
"Oh, you’re sure to do that," said the Cat, "if you only walk long enough."

If you don't have an investment plan, how will you know when you get there? For more details, I would suggest reading my previous post entitled The ABCs of financial planning as a primer on this topic.

Once you've adopted these steps, you should have a much better idea of what you want; where you want to go; and better protection against the Wolves of Wall Street.


Addendum: One sure bet
I have long believed that one of the ways to nurture youth is to give them a focus in their lives, whether it be music, sports or other pursuits. This is especially critical during their adolescent years as they start to form their own identities. It's one of the key reasons why I became involved with the Vancouver Youth Symphony Orchestra Society. Participation in a VYSO orchestra teaches young musicians to focus on both their individual musical and orchestral skills. The latter is particularly important as many people can learn to play music, but a different skill is required when the conductor points to a section and have them all play the same sound at the same time. (That's why often school bands have "muddy" sounds - it's because they haven't learned orchestral skills.) It's much like the difference between learning to walk and learning to march in formation.

This holiday season, I am launching my personal appeal for support of the VYSO's Margitta Krebs Bursary, named after the much beloved conductor of the VYSO Debut and Junior Orchestra who is retiring after 29 years.

Margitta Krebs is celebrating her 29th season as Conductor of the Vancouver Youth Symphony Orchestra's two junior string orchestras and she will retire at the end of this season. She has now seen several generations of VYSO musicians proceed from Debut to Senior ranks and is proud to have launched them. Over the last 29 years, the Debut and Junior String orchestras have tripled in size under Margitta's enthusiastic leadership.

The VYSO is excited to announce that it is founding the Margitta Krebs Bursary Fund to honour Margitta's longstanding contribution to the VYSO. The bursaries will be open to students in the Debut and Junior Orchestras and their graduates as they proceed through the Intermediate and Senior Orchestra ranks. The Margitta Krebs Bursary is intended to financially assist students who might otherwise be unable to participate in orchestral training.

If you are in the Vancouver area, please come to Margitta's Farewell Concert on Sunday, May 4, 2:30pm at the Nikkei Centre in Burnaby, B.C. The Junior and Debut Orchestras, consisting of musicians ages 8-13, will close the season with a medley of the best, featuring everything from Ashokan Farewell, to an assortment of fun favourites and a stirring finale of Bach's Brandenburg Concerto No. 3. Special guest conductor for this piece will be Mr. Roger Cole, VYSO's Senior Conductor and Artistic Director. The full calendar of the VYSO's concerts this season can be found here.

Please consider contribute to the Margitta Krebs Bursary Fund by clicking here. It's a sure bet that you'll feel better about yourself by supporting efforts like this to the young discipline and focus in their lives.

The Vancouver Youth Symphony Orchestra Society is a registered charity and tax receipts are available to contributors who are Canadian residents.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Welcome to the Santa Claus rally

In the wake of Friday's stock market rally, it appears that the seasonal Santa Claus rally is well under way. Rob Hanna at Quantifiable Edges produced analysis that initiating a long position in the NASDAQ Composite as of Friday's close (until December 20) and held for eight days would have been profitable in 24 out of 26 years. Further analysis shows that a long position in the SPX initiated at the close on Friday, December 13, and held for 15 days would have been profitable 25 out of 29 years.

In addition, Bespoke produced analysis showing the typical seasonal pattern for the DJIA and, if history is any guide, the rally is just starting and should continue until the first week of 2014. In the past, the Dow has advanced roughly 2% from now until the first week of January.

From a technical perspective, an upside potential of 2% makes sense. The chart below of the SPX shows upside potential of roughly 1850, based on the convergence of the 2 standard deviation upper bound of the weekly Bollinger Band depicted trend line. An advance to the 1850 level represents a gain of approximately 2% gain.

A pause in early 2014?
If equity prices were to rally that much that quickly, short-term oscillators would move into overbought readings and stock prices would likely pause or correct from those levels. Breadth indicators have been showing negative divergences for the last few months and they paint a picture of a rally that is running out of steam. One likely scenario is equity prices pause after the seasonally positive Santa Clause rally.

As an example of the negative divergence shown by the breadth indicators, the Net New High/New Low NYSE indicator (top panel) is showing a pattern of lower highs and lower lows while the SPX (bottom panel) continues to advance to new all-time highs. For the bullish case to hold, I would be more comfortable with this rally if the Net New High/New Low indicator were to rise above the resistance zone shown in yellow:

Similarly, there is a negative divergence in the number of stocks above their 50 day moving average. This is a sign of deteriorating breadth and fewer and fewer stocks are driving this rally. The resistance band, shown in yellow, will be more challenging for this breadth indicator to overcome as this market advances.

A similar pattern of deteriorating breadth can be seen in the number of stocks above their 200 day moving averages. The message from these different breadth indicators using different methodologies and look-back windows tell the same story of declining breadth.

Equally disturbing for the bulls who hope that a Santa Claus rally can carry on until well into 2014 is the relative performance of the small cap stocks. As the chart below of the small cap RUT compared to the large cap SPX shows, small caps have been underperforming even as the market rallied. The failure of a high beta sector like small cap stocks to assume market leadership is a knock against the longevity of this bull move.

The performance of the mid-cap stocks is also confirmation of the relative weakness of small caps. Shouldn't higher beta stocks like mid and small cap stocks be leading the market upwards if this bull phase is to be sustainable?

Q4 Earnings Season holds the key
I believe that Q4 Earnings Season will hold the key to the near-term direction for stock prices in January and February. Even Ed Yardeni, who had been relatively bullish, recently turned more cautious as he worried about the pace of sales momentum [emphasis added]:

Businesses are building their inventories of merchandise and new homes. That activity boosted real GDP during Q3, and may be doing it again during the current quarter. The question is whether some of this restocking is voluntary or involuntary.

The recent weakness in producer and consumer prices suggests that some of it is attributable to slower-than-expected sales. To move the merchandise, producers and distributors are offering discounts. November’s surge in housing starts may also be outpacing demand, as evidenced by weak mortgage applications.

In other words, the rebound in the Citigroup Economic Surprise Index over the past 10 days might not be sustainable into the start of next year. I’m not turning pessimistic about the outlook for 2014. I am just raising a warning flag given the remarkable increase in inventories recently and weakness in pricing.

I had seen the strength in the Citigroup US Economic Surprise Index as a positive, because top-line growth was lacking in Q4 Street estimates, which left share buybacks and margin expansion doing most of the heavy lifting in Q4 EPS growth (see Is a Fed taper bullish or bearish for stocks?).

The indication that we may see a near-term upside surprise in revenue growth is especially positive, because I had been concerned about the upcoming Q4 Earnings Season that begins in January. Thomson-Reuters recently deconstructed Street earnings forecasts and, as the chart below shows, consensus 4Q EPS growth depended mainly on share buybacks and "other", which is mainly margin expansion, but little or no revenue growth.

 SP 500 Components of Earnings per Share Growth

However, if the rebound in the Citigroup Economic Surprise Index is illusory, as per Yardeni, then all bets are off.

For now, my base case scenario calls for a Santa Claus rally into the first few days of the New Year. After that, we will have to wait for signs of continued growth from Earnings Season to determine market direction. I will be closely monitoring the Manufacturing PMI reports from around the world in the first week of January for early indications of economic strength.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Watch the risk premium! (Fed taper edition)

To be honest, I did not expect a December taper. That's because there was no consensus at the Fed as to what kind of forward guidance language to give Mr. Market so that it wouldn't freak out. The Fed had made it clear that "taper is not tightening". In light of the market reaction in the May-September period over the possibility of tapering, the Fed had to make it clear that they did not want forward rates to rise significantly. One alternative was to state that they would lower the unemployment threshold range before considering raising short-term rates, another was to explicitly target inflation, etc. There appeared to be no consensus.

What emerged was this compromise sentence in the FOMC statement, which appeared to spark the stock market melt-up:

The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.

We now have an inflation target in the guidance language, sort of.


What about the risk premium?
The FOMC statement had also raised economic growth and lowered unemployment projection for 2014, which is bullish for the economy and the stock market. Under conditions of rising economic growth, rising long rates should not be an impediment for stock prices because of the underlying support of rising growth and rising earnings.

While that is true of a typical cyclical recovery from a recession, current conditions are unusual because it is a recovery from a balance-sheet recession where deleveraging is occurring. Moreover, the Fed's QE programs have served not only to lower interest rates, they compressed risk premiums across the board (see It's the risk premium, stupid!).

So what happens now to the risk premium?


Rising EPS vs. normalizing risk premiums
Here is my concern. The response of stock prices to rising EPS is linear, while the response to changes in risk premium is non-linear.

Here is what I mean. Consider that if EPS rises 10% and the P/E ratio stays the same, stock prices will rise 10%. However, if the discount rate, or capitalization rate, on expected future earnings changes by 100bp, and the change consists of a combination of rising interest rates, e.g. 25bp, and rising risk premium, e.g. 75bp, then prices can change considerably.

The chart below graphically shows capitalization rate on the x-axis and the P/E ratio on the y-axis (P/E = 1/cap rate). Note how the line is depicted as a curve. A minor change in the discount rate can affect the P/E ratio disproportionately. When rates is low, a small rise in capitalization rate results in a precipitous drop in the P/E ratio.

Even if EPS rises, a Fed taper whose market reaction includes rising risk premium, can result in conditions where stock prices fall because the positive effects of rising earnings are offset by the negative effects of falling P/Es.

I am therefore carefully watching credit spreads, both in the US and globally, to how the market perceives the Fed's decision to taper. Will the risk premium rise? By how much and in what sectors? During the May-September "taperitis" period, the Fed's announcement that it was considering tapering caused emerging market bond yields to blow out and nearly resulted in an EM currency crisis.

The initial market reaction has been positive. Across the Curve describes the reaction as "financial nirvana":

Credit Spreads are on fire or as our Spanish friends would say “en fuego”. Bank and finance paper is better by 3 basis points to 5 basis points but in the 7 year and 8 year part of the curve paper is as much as 8 basis points tighter. TMT (telecom media and technology) is 3 basis points to 4 basis points better. Stocks are rallying huge and the funds rate will be at zero for the rest of out lives and maybe even our supernatural lives. So what is there to worry about as this is financial nirvana.

Consider the market reaction, which bears close monitoring in the days and weeks to come. In the wake of the Fed announcement, the relative performance of US junk bonds (HYG) soared against 7-10 year Treasuries:

EM bonds (EMB) rallied against US junk (HYG), but they faltered later in the day:

Here is the longer term chart of EM bonds relative to US junk. EM bonds never recovered from taperitis, which is a concern given the interconnected nature of the global financial system.

Watch this space! If EM spreads were to start reversing themselves and start blowing out, then the contagion could potentially spread to other markets and the result would be a catastrophic market sell-off.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

My plan for 2014

Blogging will be light until the New Year, but I wanted to share my investment plan for 2014. Here is how I see US equity market conditions right now.


A sweet spot for equities?
Current macro conditions indicate that we are in a sweet spot for equity returns. The US economy continues to revive and it is starting to show signs of growth acceleration.

As New Deal Democrat puts it, short-term and coincidental indicators are all pointing up but he is concerned about the rise in mortgage rates, a key element of his longer dated indicators that raise concerns about late 2014 and early 2015:

Coincident indicators were generally positive, but less strongly so. Steel production is positive albeit more muted. Bank lending rates remain at or near record lows. House prices remain strongly positive. Tax withholding retreated after an excellent November. Gallup consumer spending remained quite positive, despite challenging YoY comparisons, Johnson Redbook was moderately positive, but the ICSC index less so.

My mantra remains the same. The economy has bounced back in the second half of this year, and all looks well for the next 3 to 6 months. Housing and especially interest rates must be watched carefully, however, as to the end of 2014 and 2015.

In particular, the bond market's reaction to the inevitable Fed tapering, whenever that occurs, has to be watched very carefully. Will long rates start to back up and push up mortgage rates and dampen growth in the cyclically sensitive housing sector?

Meanwhile, European leading indicators are still pointing up, though coincidental indicators still look punk. The ECB has made it clear that it is prepared to give the market a Draghi Put, which is supportive of growth. China is growing, albeit in an unbalanced fashion.

Simply put, global growth is continuing and there is little or no tail risk in the immediate future. It's time to get long equities. What could possibly go wrong?


Too good to be true?
Maybe it's because I apprenticed under people who lived through the terrible bear market of 1974-75 that I worry so much, but I have this nagging feeling that these market conditions are too good to be true.

If you look, there are a number of technical and fundamental clouds on the horizon. John Murphy (subscription required) pointed out that 2014 is the second year of the Presidential Cycle, which is usually not equity friendly [emphasis added]:

According to the Stock Traders Almanac, the two first years of the four-year cycle are usually the worst with the last two usually the best. Bear markets usually occur during the first two years. Since 2013 (the first year of this term) was so strong, historical odds for 2014 (the second year) to suffer a downside correction are pretty high.

Chart 1 overlays four-year cycle lows on the SP 500 going back to 1990. The vertical bars show the last six bottoms occurring in 1990, 1994, 1998, 2002, 2006, and 2010. Earlier four-year patterns (not shown here) occurred in 1970, 1974, 1982, and 1987 (the cycle skipped 1978 while 1987 was a year late). Most of those bottoms took place during the second half of those years (mainly around October), and have coincided with midterm congressional elections. Assuming the four-year pattern repeats, the next bottom is due in 2014 and most likely during the fourth quarter. That carries both good and bad news. While the second year of a presidential term (like 2014) is usually the weakest, the third year (2015) is usually the strongest. The bad news is that 2014 is likely to experience a major stock correction. The good news is that correction should lead to a major buying buying opportunity later in the year.

Growth and Value bears come out of the closet
Besides the technical headwinds posed by the Presidential Cycle, a couple of well-respect growth and value oriented investors are turning bearish. Mark Hulbert pointed out last week that the Value Line Median Appreciation Potential, which has a growth tilt, hasn't been this bearish since 1969:

To be sure, the market may resolve its current critical juncture by headed higher rather than turning down. Yet Aronson notes that other indicators are also flashing caution.

One to which he draws special attention is known as the Value Line Median Appreciation Potential, or VLMAP, for short. This represents the median of the projections made by Value Line’s analysts of where the 1,700 widely followed stocks they closely monitor will be trading in three to five years’ time. But for brief exceptions, the VLMAP currently is lower than it’s been in many decades.

For example, the VLMAP today stands at 30%, where it’s been for seven straight weeks. Prior to the October 2007 peak, it got this low for just one week. And it never got this low in the months leading up to the 2000 market top.( Read a column I devoted earlier this year to the VLMAP. )

In fact, you have to go all the way back to early 1969 to find another time in which the VLMAP spent as long a period at 30% or below. From then until the market’s December 1974 low, of course, the Dow fell more than 40%.

As well, legendary value investor Warren Buffett has stated while equities look fairly valued, he can't find anything to buy, though he did allow that

[Buffett] noted that the equity market was fairly valued and stocks were not overvalued. Specifically, Buffett said “They were very cheap five years ago, ridiculously cheap,” and “That’s been corrected.” He also noted, “We’re having a hard time finding things to buy.” One has to take note when the world’s most high profile investor (a long investor), cannot find stocks to buy although he reports his business is improving.

This is a case of watching what Buffett does, not just what he says. When he says that he can't find anything to buy, you have to start getting cautious. When both Growth (VLMAP) and Value (Buffett) are cautious, then investors have to get especially wary.


Positive momentum, long term caution
The combination of positive short-term indicators and analysis from Value Line, Buffett et al point to the same thing. Short term momentum remains positive and stocks remain in a multi-year uptrend...

...but longer term indicators, such as valuation (VLMAP and Buffett) and longer dated economic indicators (New Deal Democrat), are flashing caution signs. So markets rally for now, but watch out as we approach late 2014.

My base case scenario calls for stock prices to continue to grind upwards until mid-2014, at which point some unknown catalyst is likely send equities downwards. Some time during Q2 and Q3, I would have to re-evaluate the macro conditions and re-position portfolios accordingly.

Today, the VIX at levels that are low by historical standards, indicating that the price of downside put protection are relatively cheap. Investors should consider staying long equities today but starting to accumulate cheap put protection into mid-year.

2014 is sounding like a good year to be selling in May and go away.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

The Chinese elephant in the room

In my last post (see Is a Fed taper bullish or bearish for stocks?), I outlined a cautiously optimistic growth outlook for the American economy. In another post (see More reasons to buy Europe), I outlined a bullish scenario for Europe. While these two major regions in the world appear to be recovering nicely, the elephant in the room that no one wants to talk about is China.

There is no question that China's rate of growth has been slowing for the past few years. Mr. Market has been showing his concern as well. My framework for analysis is the relative return of the country market ETFs of China and its major trading partners against the MSCI All-Country World Index ETF (ACWI). That way, all returns are denominated in USD and therefore any exchange rate effects are neutralized.

Here is the relative returns of FXI, the China ETF, against ACWI. FXI has been in a multi-year relative downtrend showing a series of lower lows and lower highs on a relative basis:

Here is EWH, or the Hong Kong ETF, against ACWI. While the relative downtrend is less pronounced and EWH is approaching a relative support level, the relative trend nevertheless remains down.

The relative returns of EWT, the Taiwan ETF, tells a similar story of multi-year underperformance.

Here is EWY, or the South Korea ETF, against ACWI. It's not a pretty picture, but you get the idea.

The most alarming relative return chart of the region belongs to EWA, the Australia ETF. It recently violated a major relative support area, with little signs of relative support below. I interpret this as Mr. Market telling us that the era of Chinese infrastructure-led growth, which stimulated outsized commodity demand, is over.

Silver linings
The risk for the global economy is that a slowdown in China, if not properly managed, has the potential to turn into a crash landing. Given the financial linkages that exist around the globe, the financial contagion from a Chinese crash landing would likely spread around the world and create another Lehman or Creditanstalt style event.

Fortunately, silver linings are starting to appear. From a short-term technical viewpoint, the Shanghai Composite managed to stage a rally through a downtrend. This may be the early signs of stabilization.

Political purges ahead?
As well, I had speculated that what China needed is a purge for the new leadership to consolidate power so that it can properly end, or at least lessen, the practice of financial repression in order to re-balance the growth in the economy (see Does China need a "Night of the long knives"?):

In order to achieve its stated goal of re-focusing growth from export and infrastructure to the consumer, the authorities would have to stop, or at least lessen, the financial repression of the household sector with higher wages and interest rates for household savings. All those steps would hurt the interest of the Party insiders who got filthy rich.

I concluded that a purge may be necessary:

If China's top leadership really wanted to signal the seriousness of its intention of re-balancing growth and market based reforms, maybe what it needs is a Night of the Long Knives, which refers to an event in 1934 when Adolf Hitler instituted a purge of his enemies. One of the victims of the purge was the SA, otherwise known as the brown-shirts, because they had outlived their usefulness.

Maybe what China needs is its own purge of Party cadres, because they have outlived their usefulness and become an impediment to stable long-term growth.

Michael Pettis more or less said the same thing in this post that is well worth reading in its entirety. He began with his longstanding warnings about the need to re-balance growth in China and the road ahead is difficult. In particular, the elites will have to suffer, at least on a comparative basis [emphasis added]:

[E]very country that has experienced a growth miracle has also developed imbalances that had to be reversed, and the adjustment process is simply the process by which these imbalances are reversed. China is no exception. In order to rebalance the Chinese economy we must move from a period during which the elite received a disproportionate share of growing Chinese wealth to one in which ordinary households and small businesses receive a disproportionate share. After thirty years during which Chinese households retained an ever smaller share of the rapidly growing Chinese economy, doing nonetheless very well in the process, we must shift to a period during which ordinary Chinese households receive an ever rising share of a more slowly growing Chinese economy, in fact this is almost the very definition of rebalancing in the Chinese context.

Economic adjustments mean political adjustments as well, especially given the type of political system that exists in China. Pettis appears to be cautiously optimistic as the leadership knows what needs to be done:

History has a lot to teach us about this process, and it has a lot to teach us about which countries were able to manage the difficult adjustment in ways that created a basis for long term success and which countries were not able to do so. China’s leaders have already demonstrated sufficient foresight and ability to have managed the growth period successfully, and we have every reason to hope that they will manage the adjustment process equally well. But there should be little doubt that thirty years of astonishing growth was the relatively easier part, and that President Xi Jinping and Premier Li Keqiang face a greater challenge than that faced by their predecessors. And there should also be little doubt that the recent political turmoil in China is not an accident. History makes it very clear that the next ten years will be a political challenge for China even more than it will be an economic one.

He concluded that a purge "political step backwards" may be necessary:

[A] successful adjustment in China actually requires that China move temporarily “backwards” towards greater centralization of power and a tighter grip on decision-making by President Xi and his allies. After all it took Deng Xiaoping to unleash the radical reforms of the 1980s, and it is an open question as to whether he would have been able to do so had political power in China been as dispersed in the 1980s as it is today. In that sense what seems like an attempt by President Xi to consolidate power more tightly within a small group is perhaps not a step “backwards” in political liberalization but more of a temporary retreat in order to ensure a successful adjustment, which itself might be a precondition to further political liberalization some time in the future.

There are signs that the "political step backwards" may be starting to happen. Business Insider recently highlighted the unusual political development of the arrest of former Politburo member Zhou Yongkang:

Zhou Yongkang, China's former security chief, has been placed under house arrest while the government investigates him on charges of corruption and "violating party discipline." He's the most powerful politician to go down since the Communist party took over in 1949, and his arrest is more evidence that President Xi Jinping is embracing authoritarianism in a big way.

Think of Zhou's arrest like the President taking down the retired head of the FBI or the CIA.

The difference in China, though, is that those two security apparatus' are controlled by the party, and within the party, Zhou still had a great deal of influence. He's a former members of the Politburo Standing Committee (the 7 to 9 men that run the country) and in arresting him "Xi has broken with an unwritten understanding that members of the Standing Committee will not be investigated after retirement," writes the South China Morning Post.

This is a key development that suggests that President Xi Jinping is consolidating power. In all likelihood, the purges will spread and the markets may freak out over the prospect of political turmoil in China.

Should the markets sell off because of these political developments, it could be a buying opportunity. I agree with Pettis that some measure of authoritarianism (think Singapore) and power consolidation may be necessary for China to move ahead to the next phase of growth. Such political developments should be viewed in a bullish, rather than bearish, context.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Is a Fed taper bullish or bearish for stocks?

There is no question about it, last week's US high frequency economic releases tilted heavily to the positive side. The NFP biggie came in ahead of expectations, as well as a whole host of other numbers.

Not surprisingly, the Treasury yield curve has steepened accordingly. The graph below shows the difference between the 2s and the 10s, which bottomed out in 2012 and has been steepening for most of this year.

An equity friendly environment
These developments that point to an improving economy should be equity friendly. Ed Yardeni encouragingly pointed to his analysis showing how changes in Manufacturing PMI tend to lead aggregate revenues for equities. While he expressed some doubts over the recent M-MPI spike, he did allow in later posts (see here and here) that a growth acceleration was real.

The indication that we may see a near-term upside surprise in revenue growth is especially positive, because I had been concerned about the upcoming Q4 Earnings Season that begins in January. Thomson-Reuters recently deconstructed Street earnings forecasts and, as the chart below shows, consensus 4Q EPS growth depended mainly on share buybacks and "other", which is mainly margin expansion, but little or no revenue growth.

 SP 500 Components of Earnings per Share Growth

If we do seen an upside surprise in revenues, then stocks prices could soar because of better than expected Q4 EPS.


How does the Fed react?
These signs of a growth acceleration begs the BIG QUESTION. How does the Fed react in the face of thes signs of growth acceleration?

No doubt, tapering will be on the table at the December FOMC meeting (though Fed watcher Tim Duy thinks that a December taper is premature). Regardless, the question of a taper is only a question of when, not if. However, Ben Bernanke, Fed governors and regional Fed Presidents have mostly been emphasizing the message that "tapering is not tightening", especially when the markets freaked out during its May-September bout of "taperitis".

My base case is that when the Fed does taper, it will manage guidance in such a way to underline the message that "tapering is not tightening". Though there seems to be some controversy over the practice, but the most likely course of action is a policy to lower the unemployment threshold before tightening, as outlined by this Jon Hilsenrath article:

One idea under discussion is to lower that unemployment threshold from 6.5%, which could mean keeping rates down longer. Fed staff research suggests the economy and job market might grow faster, without much additional risk of inflation, if the Fed promised to keep rates near zero until the unemployment rate gets as low as 5.5%. Goldman Sachs economists predict the Fed will lower the threshold to 6% as early as December and reduce the bond-buying program at the same time.

Bearish tripwires
Even though the news of an improving American economy appears to be equity bullish, here are the two bearish tripwires that I am watching for when the Fed begins to taper:

• Does the Fed give the market some sugary syrup to help the tapering medicine go down? (See discussion above about the unemployment threshold).
• How does emerging market bonds and currencies react?

The second consideration is especially important as the last round of "taperitis" almost sparked an emerging market currency crisis as the prospect of QE withdrawal pushed up global risk premiums (see It's the risk premium, stupid!). The chart below of the relative performance of EM bonds against US high-yield bonds, i.e. junk vs. junk, indicate that EM bonds have not really recovered from that episode and could be at risk should the markets react and push global risk premiums higher.

I am therefore watching the EMB/HYG pair, as well as the performance of CEW, which is the EM currency ETF carefully for signs of global contagion from a Fed taper.

Indeed, JP Morgan analysts highlighted Brazil and Indonesia as the most vulnerable economies once the Fed begins to taper:

The mere mention of Federal Reserve tapering can pressure various emerging markets currencies, but two could be especially vulnerable when the Fed finally does pare its bond-buying efforts.

The Indonesian rupiah, already this year’s worst-performing emerging markets currency, and the Brazilian real are J.P. Morgan’s picks among developing world currencies that are vulnerable to Fed tapering.

“The risk is [even] higher for expensive currencies. Both BRL and IDR are overvalued versus their 10 year average REER,” Barron’s reported, citing the bank.

The EM Apocalyptic scenario
The EM elephant in the room is China. A Fed taper has the potential to topple China into a global financial crisis that drags down the global economy.

Here's why. Consider that the RMB is pegged the the USD and it has been appreciating slowly against the Dollar. Also consider the fact that Chinese government 10-year paper is yielding around 4.5% while US Treasury 10-year is about 2.9%.

What would a trader do under these circumstances? Supposing you saw paper denominated in a currency pegged to the USD (but steadily appreciating) has a yield significantly higher than Treasury yields. Isn't that an open invitation to a carry trade?

Fortunately for the world, the RMB is not a freely convertible currency. Otherwise we would see every hedge fund piling into that trade and levering their exposure up 10 or 20 times and creating incredible global systemic risk. The main participants who are getting into that trade right now are Chinese companies that export and manipulate transfer pricing between their onshore (Chinese) entity and their offshore subsidiaries. Nevertheless, the exposure could be considerable and a Fed taper would be a signal to start the unwind of this carry trade. When the markets start to unwind a carry trade that is highly levered, the results are never pretty.

While I am not forecasting that such a catastrophe will happen, I am allowing for that possibility and watching market developments carefully.


Equity bull or bear?
Viewed in isolation, rising corporate revenues and a steepening yield curve in response to an improving economy are equity bullish factors. Investors, however, have to realize that they live in a global economy and they need to watch for the global effects of Fed actions.

Will the Fed be successful in convincing the markets that "tapering isn't tightening"? Does "not tightening" mean that risk premiums will rise, or when they remain compressed at current levels?

My best guess right now is that the Fed will be moderately successful in its messaging and US stock prices will continue to grind higher into 2014. However, I am acutely aware of the risks involved and therefore watching carefully the Fed's actions and how EM bonds and currencies react.




In a future post: I will discuss the fly in the ointment to the growth scenario.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

More reasons to buy Europe

Further to my last post that made the case for buying European small cap stocks (see How to stretch the Santa Claus rally into 2014), I came across further analysis supportive of my bull case for Europe and European small cap stocks.

Firstly, John Mauldin's Outside the Box publication this week highlighted Niels Jensen's rant against quantitative easing. In part, it discussed how eurozone banks remain on ECB life support:

When talking about the financial sector and how they have been able to take advantage of QE to re-capitalise their damaged balance sheets, it ought to be said that QE has effectively allowed banks to ignore their underlying problems. QE has become a life support machine for the financial sector at virtually no cost to them but at a significant cost to the rest of society. That cannot go on ad infinitum. At some point in the not so distant future it will be financial reckoning day for the sector which bodes particularly badly for the European banks, most of which are way behind their U.K. and U.S. peers in terms of cleaning up their balance sheets.

Further, Jensen pointed out the dire straits that Spanish companies have found themselves in [emphasis added]:

The IMF provided some very granular information on the state of European banks in their most recent Financial Stability Report. More than 50% of Spanish companies with loans in Spanish banks have an interest coverage ratio of less than one. In other words, the EBITDA of over half of all Spanish corporates does not even cover their interest expense (you would expect a healthy corporate borrower to have an interest coverage ratio of 3-5 times depending on the nature of the business). What's worse, the situation in Italy and Portugal is only marginally better. All of these problems have been largely ignored since the ECB stepped in with their brand of QE about two years ago and saved the European banking sector from a complete meltdown, but few, if any, of the underlying issues have yet been addressed.

I recognize that Jensen was trying to point out the futility of the ECB's QE programs and the precariousness of the system even after all this central bank intervention. No doubt, a high degree of apparent systemic risk exists.

By contrast, my investment philosophy is to be politically agnostic and Jensen's writings smack too much of "what I think policy should be" rather than "how do I make money from the current environment". I would therefore turn Jensen's analysis on its head and ask the following rhetorical question:

If the ECB has demonstrated that it intends to supply the market with a free put option, then why not take it and go long?

Free ECB put = Buy Financials
Indeed, the relative performance of European financials look constructive in light of the ECB's free put. The chart below of the relative returns of Financials show that their relative performance bottomed out in late 2011 and the sector has been in a relative uptrend since the summer of 2012.

Still risk-on in Europe
Despite the softness in European equities in the last few days, the underlying environment still calls for a risk-on stance in European equities. My last post highlighted the upside potential in European small caps (see How to stretch the Santa Claus rally into 2014). The chart below shows the relative performance of DFE (European small cap ETF) against FEZ (European large cap ETF).

There are two takeaways that are encouraging for the bull case in European stocks. First, high beta small caps remain in a relative uptrend against large caps. Second, small caps are still outperforming despite the recent sell-off.

The combination of a free ECB put and positive small cap outperformance in the face of weakness are suggestive of further gains in European stocks. Any weakness is likely to be a temporary pullback and should be viewed a buying opportunity. I would be inclined to focus on sectors and groups showing a high degree of leverage to a recovery, such as European financials and small cap stocks.


Disclosure: Long DFE




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

How to stretch the Santa Claus rally into 2014

The Santa Claus rally has been associated with a stock market rally in December. Mark Hulbert explains:

There is one version of the Santa Claus rally that enjoys strong historical support: the last five trading sessions of December and first two of January.

This year, for example, a trader wishing to capture this rally would buy stocks as of the close on Dec. 23 and sell them at the end of the trading session of Jan. 3. Traders have been aware of this particular version of the Santa Claus rally at least since 1972, which is when the editors of the annual Stock Trader’s Almanac say they discovered it.

The superior performance appears  to be most pronounced in small cap stocks:

Norman Fosback, editor of Fosback’s Fund Forecaster and former president of the Institute for Econometric Research, says that seasonal patterns in large-cap stocks have “receded in significance” in recent years.

Unfortunately, the smallest-cap stocks for which seasonal patterns remain the strongest also tend to have the highest bid-ask spreads.

These “microcap” stocks — a loosely defined category that contains issues that are even smaller than the small caps—tend to range in size between $100 million or so and $1 billion in total market value.

Fosback nevertheless favors the microcap category for the seasonal portfolio he recommends to clients, though not by buying and selling individual stocks. Instead, he prefers the iShares Micro-Cap ETF, with an expense ratio of 0.72%. The fund replicates the performance of the smallest 1,000 stocks in the Russell 2000 Index RUT +0.14% ; the average market cap of the stocks it owns is $420 million.

Small cap seasonality charted
Indeed, the seasonal pattern of the relative performance of small cap stocks, as represented by the Russell 2000, show that they tend to outperform late in the year:

Russell 2000 seasonality

The seasonal pattern of the iShares Micro-Cap ETF (IWC) is even more pronounced than the Russell 2000:

IWC seasonality

An European small cap opportunity
However, there may be a way of extending the positive effects of small cap seasonality well into the New Year. I discovered that European small caps have a tendency to outperform in both January and February. The chart below shows the relative return pattern of DFE, which is an ETF representing European small cap stocks, against FEZ, which is an ETF representing eurozone large caps.

DFE vs. FEZ seasonality

The relative returns of DFE against FEZ show that European small caps remain in a multi-year relative uptrend compared to large caps and the trend is supportive of further small cap outperformance.

Underpriced growth
In addition, there appears to be strong fundamental support for European equities. Thomson-Reuters analyzed the consensus implied forward EPS growth rates compared to the Starmine (smart analyst) estimates and found that the Starmine estimate for Developed Europe is 6.0% compared to the market implied estimate of 0.6% - a considerable spread.

By way of comparison, the equivalent figures for North American is a Starmine growth rate of 8.0% compared to a market implied growth rate of 6.1%. While the spread is positive, this analysis suggests that the opportunity is better in Europe.

Under these circumstances, I would be more inclined to focus on European small caps as they tend to be more exposed to the local economies than the large caps, which has a relatively large weighting in global companies such as BMW, SAP, EADS (Airbus), pharmaceuticals, luxury goods makers, etc.


Will the ECB provide a tailwind for small caps?
As well, the ECB may be coming to the aid of European companies. Last week, David Keohane at FT Alphaville highlighted an ECB "trial balloon" which would provide greater liquidity for SMEs. If such a step were to be taken, it would provide a greater boost the European small cap space [emphasis added]:

The European Central Bank is considering a new long-term liquidity operation available only to banks that agree to use the funding to lend to businesses, a German newspaper reported on Wednesday, citing sources.

ECB President Mario Draghi and other Governing Council members have repeatedly mentioned the option of conducting more liquidity operations, or LTROs, to help the fragile euro zone economy and ensure the flow of credit to the private sector.

The ECB extended more than one trillion euros ($1.36 trillion) of cheap three-year loans to banks through two long-term refinancing operations in late 2011 and early 2012.

But this time, an option under consideration is that the banks would have access to funding via the LTRO only if they agree to pass on the money in loans to industrial, retail and services businesses, Sueddeutsche Zeitung reported on Wednesday.

The new LTRO could also run for only nine or 12 months, the paper said.

In conclusion, traders who want to play the small cap Santa Claus rally may wish to rotate from US small caps into European small caps in the New Year..The combination of positive seasonality, undervalued growth potential and possible ECB support for SMEs suggests that European small cap stocks are likely to see a tailwind heading into 2014.




Full disclosure: Long DFE


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Rising systemic risk in China?

I got quite a few responses to my post when I speculated about the possible outcome of a Chinese hard landing (see What a Chinese hard-landing might look like). Many readers took offense at what I wrote and characterized it as fear-mongering.

They got me wrong. No one knows whether China will experience a hard landing, but I sketched out several scenarios IF China should hard land.

I did, however, offer the opinion that the risks of a hard landing was rising. Last week, we saw further signs indicating that systemic risk is rising in China.


When does the credit bubble pop?
To set the stage, FT Alphaville highlighted research from Nomura indicating that the entire region is vulnerable as a major credit bubble seems to be forming:

Past financial crises in major economies are often preceded by the private credit-to-GDP ratio rising sharply by 30 percentage points (pp) in the five years before the crisis. We call this the “5-30” rule, and many Asian countries have either breached, or are close to, the 30pp since 2008 (Figure 24). Asia is also experiencing house price booms. If we overlay residential property prices in the US (indexed to 100 in January 2000) on residential property prices in several Asian countries, it is striking how many Asian property markets are tracking above the US price bubble.

The x-axis of the chart on the left shows how the private credit-to-GDP ratio has risen for the Asia Ex-Japan region. Note how China and Hong Kong are the outliers and literally off the chart compared to the other countries. In the right chart, Nomura overlaid the path of the property prices in the pre-Lehman US to other countries in the region to highlight the rising level of systemic risk.

Riding around without a helmet
Just because a system is increasingly risky doesn't mean that a crash will happen. It just means that you have a risky system.

The best analogy is a motorcyclist riding around at 100 mph without a helmet. It doesn't mean that he is going to get hurt, it just means that the results will be very ugly if he does get into an accident.

You need a catalyst for the accident to happen, or, to use the motorcyclist analogy, a pothole in the road.

We may be seeing that pothole in the road ahead and the credit markets are starting to price in the risk of a meltdown, according to Bloomberg [emphasis added]:

Chinese companies’ borrowing costs are climbing at a record pace relative to the government’s, increasing the risk of defaults and prompting state newspapers to warn of a limited debt crisis.

The extra yield investors demand to hold three-year AAA corporate bonds instead of government notes surged 35 basis points last week to 182 basis points, the biggest increase since data became available in September 2007, Chinabond indexes show. That exceeds the similar spread in India of 120 basis points. The benchmark seven-day repurchase rate has averaged 4.47 percent in November, the highest since a record cash crunch in June and up from 3.21 percent a year earlier.

“Existing interest-rate levels and tighter credit conditions will pose downward pressure on growth,” said Kewei Yang, head of Asia-Pacific interest-rate strategy at Morgan Stanley in Hong Kong. “Any potential defaults or bankruptcies in 2014 will trigger the market to reprice credit risk.”

Markets are getting worried by the excessive leverage:

The nation’s total debt, led by state-owned enterprises and local governments, may exceed 200 percent of gross domestic product, according to a Barclays Plc report yesterday. Implicit government guarantees and soft budget constraints have encouraged excessive borrowing and increased the potential for defaults, the analysts wrote.

These guarantees are now looking increasingly uncertain with China’s Communist Party saying at the Nov. 9-12 plenum that it would encourage private investment in state-owned enterprises, which have enjoyed sheltered monopolies for years, and allow competition. The leadership pledged also to give markets a “decisive” role in the allocation of resources.

Could this be a tipping point?

I wouldn't panic. My Chinese canaries, which measures the price performance of Mainland banks listed in Hong Kong, are still quite healthy and behaving well - for now.

Nevertheless, these signs of increasing anxiety in the credit markets need to be monitored - just in case these jitters turn out to be something more serious.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.