Profiting from the Collapse of the China Bubble

The collapse of the Chinese stock market is a not a question of “if” but of “when.” In late February 2007, the index dropped by 9% in a single day on fears that the Chinese government was moving to crush speculation in stocks. The market subsequently rebounded. The China investment game has turned from investment into pure speculation. As with the Internet, you just have to make sure you have a seat when the music stops in what has turned into a game of Chinese musical chairs. This week’s Global Bull Market Alert pick reflects my view that the recent correction on the Chinese market means that it’s time to take a seat. Here’s why.

First, the Chinese stock market boasts all the elements of a textbook financial bubble. At the end of the 1980s, a list of the most valuable companies in the world was all Japanese. Today, Chinese companies can claim the world’s largest market capitalizations in banking, insurance, telecoms and airlines.

Every bull market has its iconic moment. For the Japanese, it was when all of the land under the Royal Place in Tokyo was worth more than all of the land in California — or Canada. China’s moment may have been the listing of PetroChina on the domestic stock exchange. By the end of the first day of Shanghai trading on Nov. 5, investors pegged the company’s market capitalization at more that $1 trillion. Its market cap now exceeds that of Exxon Mobil and General Electric combined, the second- and third-biggest companies in the world, respectively.

Second, technically, the market has gone asymptotic even as trading volume has exploded. Since the last major low in 2006, the slope of the advance has changed half a dozen times, getting steeper every time. This is very typical of a speculative blow off, and more often than not, things end badly. In fact, if you place the chart of NASDAQ over the chart of the Chinese index, it is hard to tell them apart.

Third, there are anecdotal signs that panic is replacing bullishness among the Chinese retail investors who have seen the Chinese stock market only as a one way bet. The giddiness of the bubble is starting to be replaced by pervasive gloom. Even last night, as Asian markets rallied, the domestic Chinese markets went down.

Finally, even some of you reading this may be saying in your minds: “this time it’s different.” Realize that you’re repeating what investment doyen John Templeton called the “four most dangerous words in investment.” A month ago, Chinese retail investors brushed aside any suggestion that U.S. markets could affect equity values in China. Many U.S. investors also believed that the government would do nothing to damage confidence in stocks before Beijing hosts the 2008 Olympics next summer. Don’t you believe it. The Chinese government on Nov. 15 issued a report warning that a U.S. recession could be "devastating" to China’s manufacturing sector. In recent weeks, regulators ordered commercial banks to freeze lending activities through the end of the year — a major step calculated to curb the country’s overheated economy that already is having a knock-on effect on share prices.

This week’s Global Bull Market Alert pick is a way to profit from the collapse in China. ProShares recently launched an exchange-traded fund (ETF) that moves opposite of an index that trades shares of Chinese companies on the Hong Kong stock exchange. The Ultrashort FTSE/Xinhua China 25 Index (FXP) corresponds to twice (200%) the inverse of the daily performance of the FTSE/Xinhua China 25 Index. That means that if the FTSE/Xinhua China 25 declined by 1% in a day, the UltraShort FTSE/Xinhua China 25 ProShares will appreciate by 2%. Conversely, if the benchmark rises by 1%, the ETF will decline by 2%.

So let’s buy UltraShort FTSE/Xinhua China 25 Index (FXP) at market today, and place our stop at $40 — a wide stop based on the ETF’s volatility. Because of the ETF’s leverage and volatility, I recommend that you take only one half of your normal position size in this week’s recommendation. Also, realize that this pick is designed to zig when others zag. So when markets rally into December — as I expect them to do — this may be an uncomfortable position to hold. But on bad days in the market, you can expect this position to soar.

For those of you who want even more leverage through options, I recommend you buy the May $170 puts (FVUQN.X) on the (unleveraged) iShares FTSE/Xinhua China 25 Index (FXI).

PORTFOLIO UPDATE

We were stopped out of four of our positions last week. BHP Billiton (BHP) gained 14.86%, DryShips (DRYS) ended up 4.09%, while Cameco (CCJ) and Unibanco (UBB) incurred slight losses. Overall, our Global Bull Market Alert portfolio is well-positioned for a Santa Claus rally.

Some of you have written asking for advice on what to do in such turbulent markets. As long as you know your stops — and stick to them — you will be fine. You know your worst case scenario. Rest assured that you are receiving some of the most sophisticated advice around on this front. Keep an eye out for future issues of The Global Guru, since I expect to be writing more on some of the basic principles of money management in the weeks ahead.