Recent volatility in China equities suggests a prevalence of margin trading. The article analyses the buying behaviour of strategic investors, margin traders, the Stock Connect Schemes and ETFs and predicts more volatility in the near term.
Prevalence of margin trades a source of volatility:
The recent torrid market ascent and then descent suggest strongly the prevalence of margin trades. Such epic volatility is reminiscent of 2015. How else could we explain the diverging YTD performance of Hong Kong and mainland markets driven by a similar set of fundamentals? We have investigated the buying behavior of strategic investors, margin traders, the Connect Schemes and ETFs. Except for strategic investors who are natural long in stocks and are thus prone to reduce their stakes, margin traders, the Connect Schemes and China-focused ETFs have all been buying – not surprising at all. Now, the more important question is what different buying mean for the market outlook.
Regulator’s tolerance towards margin trades unclear; percentage of turnover in margin trades as proxy:
The changes in margin trading activities have the closest correlation with the market surge. Whether the percentage of total turnover in margin trades can penetrate its upper limit of 12%, as suggested by the experiences in recent years, can be applied as a quantitative proxy to monitor the regulator’s tolerance towards margin trades. It is now close to 11%; the OTC financing in Guangdong is being investigated, and brokers are advised against working with the OTC financing vendors. But it is also reported that index futures trading could be normalized by year end. As such, the regulator’s attitude towards margin trades is for now inconclusive.
Margin trades with lower overseas interest rate buying via Connect:
ETF inflows and the Connect Schemes have been buying since early 2018. As such, this so-called foreign buying has little market timing potency, and forestalls little for the outlook. Further, ETF inflows have started to wane, and can even reverse in the coming weeks. Margin trades on lower HK interest rates have hit the buying limit on some of the constituents of the scheme. These margin trades have bought into companies with an average dividend yield of ~ 2%, offsetting some of their interest costs. With a prospect of handsome gains, the motive for these margin trades to buy into the mainland via the Connect Schemes is strong. They can also be a source of market volatility.
Long-term trend trumps short-term moves:
The regulators are unlikely to make up their mind towards margin trades shortly – much like in 2015 when there were many zigzags and eventually a U-turn. As such, the volatile market condition in the near term is a fertile ground for speculation. Our short-term trading model suggests caution, while our long-term allocation models continue to show attractive valuation for the A shares. Such conflicting messages will likely oblige short-term traders to hand over their positions to long-term investors. The consequent rotation from short to long term will induce volatility, skewing risk versus reward temporarily. Yet, to us, the long-term trend trumps short-term moves.
Who is Buying This Rally?
“Stay hungry, and stay foolish. Or watch your neighbors get rich - like an economist.” – Chinese stock market jibes
The other day, I was in the office elevator on my way to work. I couldn’t help but notice an unusual congregation of mum-and-pop investors packing the elevator with me. They were probably going to one of the brokers in the building to sort out their accounts. It felt good when fully loaded on our way up.
Suddenly, there was a tap on my shoulder. I turned and met a pair of earnest eyes. “You are that guy,” he grinned. “I saw your show the other day. Could you please give me some tips?” I was flattered; face blushing like a boiled lobster.
But before I had the opportunity to answer his question in the professional sell-side fashion, another pop nudged him and whispered: “Don’t ask him. He has been in the market for too long. He wouldn’t dare to chase higher. ” The logic was so flawless for me to come back nicely in a short elevator ride. “You should ask a newbie. They are gutsier. You will make more money.” The elevator doors behind me squeezed out the final verdict.
Who bought this rally? It is a pertinent question besetting investors. But more importantly – what does it mean for the market outlook when different types of fund buy? Knowing the answer, or at least some approximate truth, will be the key to determine whether the show will go on.
In our last note, we postulated that it was the margin trades that have been instrumental to the current surge (“A Margin Bull. What Next?”
20190301). After all, it would be difficult to explain the torrid volatility. Further, based on recent trading history since late 2015, when the percentage of total turnover in margin trades is close to its upper limit of ~12%, the regulator may intervene. And the latest data show that this percentage stays elevated at close to 11% (Figure 1
Our report was published on Friday, March 1, 2019. The SSE50 blue chip index peaked out on the following Monday, March 4, 2019. From its peak to its last close, the blue chip index has declined by ~8%.
Already, it is reported that the CBIRC fined two banks in Taizhou for negligence of letting some of their loans into the stock market. Further, the CSRC Guangdong Branch was reported to have hosted a meeting regarding OTC margin financing, explicitly advising brokers not to cooperate with OTC financing companies as they did in 2015, and asking brokers to step up monitoring abnormal trading activities and to improve investor education. But the CSRC also mentioned briefly that it had been studying the feasibility of normalizing the stock index futures trading probably by year end. This news confirms that talks that have been on the street for some time.
Figure 1: Margin trade as a percentage of turnover stays elevated and close to its limits since late 2015
Source: CEIC, BOCOM Int'l
These recent developments are consistent with past experiences as the percentage approached its upper limit. Going forward, we can apply this measure as a proxy of regulatory scrutiny, and as an alert of looming market resistance. When this percentage significantly penetrates its upper limit, it would suggest that regulators’ attitude towards margin trades is shifting, and it would be constructive to risk appetite – or even a repeat of the 2015 bubble.
But the calculation of this percentage is a dynamic process – as more and more cash trades crowd into the market, the percentage turnover in margin trades will decline, and the trajectory of the staggering surge will likely decelerate. As such, we need to investigate who else have been buying the rally.
Consensus also believes that it is the foreign inflows into China-focused funds that have been buying, implying that these buying has been pushing up the market. But the evidence in data is inconclusive. We note that these China-focused funds tend to be early in their buying, and slow the accumulation or even reduce stakes in the Chinese market as the indices rise.
For instance, the cumulative inflows of these ETFs climaxed in late 2014 – just before the Chinese market was about to soar. Then, the pace of buying started to decelerate, and later turned into net outflow as the market crashed (Figure 2, upper panel
). Such behavioral patterns are most likely to be caused by investor’s planned fixed investments over time, as well as heavy redemptions as the market falls.
When comparing shorter-term, rolling periodical cumulative ETF inflows with the market return for the corresponding period, we can show that the speed of these funds’ inflow is a contrarian indicator of these funds’ return (Figure 2, lower panel
Given this historical relation between periodical return and cumulative inflow has been strong and persisting, and the market has been surging of late, we will likely see net outflows from these funds – opposite to the trend in the past few months. As such, these inflows, even if their buying has been supportive for the market, they are unlikely to continue to be as supportive for the market in the near term.
Figure 2: Inflows of China-focused ETFs, a contrarian indicator of return, are waning
Source: Bloomberg, BOCOM Int'l
Strategic Investors (Industrial Capital)
Consensus also observes that strategic investors have been cutting their stakes amid this rally. In general, this is believed to be a bearish sign, as these monies tend to be long-term strategic partners with intertwining relationship with all facets of the listed companies. If they depart, it is assumed that retailed investors will be left holding the bag.
Once again, data evidence does not support such popular belief. Indeed, strategic investors have been reducing stakes all the way up or down, as seen by the close correlation between the cumulative reduction of stakes and the capitalization of the market (Figure 3). That is, as the natural long-only of the market after accumulating stakes in public companies, strategic investors could only reduce their stakes as the market rises. Their selling suggests quite little, but their buying may indeed suggest a market with value.
Figure 3: Industrial capital, the natural longs, has been reducing its stakes regardless of market conditions
Source: Bloomberg, Wind, BOCOM Int'l
Can the strong inflows from Hong Kong through the Connect Schemes be the drivers of the current rally? Weekly inflow data of the schemes show that these monies are not very good market timers – they tend to buy regardless of market directions (Figure 4). As such, the connotation of their buying for the market is also inconclusive.
That said, there is evidence that margin traders borrowing from Hong Kong at a very cheap interest rate, and then going through the schemes into the mainland market. It is difficult to gauge the magnitude of these trades. But given the interest spread between the mainland and Hong Kong, as well as the prospects of handsome gains, the motive for such trades is strong. If so, this type of margin trades from Hong Kong will be an additional source of market volatility in the near future.
Figure 4: Buying through Connect Schemes has been surging, but it has little market timing power
Source: Bloomberg, Wind, BOCOM Int'l
In one of his classics “A Short History of Financial Euphoria”
, John Kenneth Galbraith observed two further factors contributing to and supporting the financial euphoria, besides some radical new idea capturing the crowd’s imagination and new instruments for easy financial leverage.
“The first is extreme brevity of the financial memory,”
he wrote. “In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”
The story about the chitchats in the elevator we recounted at the beginning of this paper suddenly rings rather familiar.
It is difficult to argue against the foundation of the recent rally. After all, our long-term allocation models, based on cycles, relative valuation and market technical, have all turned just prior to this rally (Figure 5
). We have discussed these model results in our outlook report “Outlook 2019: Turning a Corner”
(20181119) and a follow-up report “Turning a Corner: Teachings from the ‘Dog’”
Figure 5: Our proprietary EYBY model suggests long-term allocation value towards A shares
Source: Bloomberg, BOCOM Int'l
In the near term, however, we believe that the margin trades could get even more rampant before the regulator tolerance towards these trades is known. We would use the percentage of total market turnover in margin trades as a quantitative proxy of the regulator’s attitude. We believe that it would be more constructive for the market if the activities of these trades are to be regulated and monitored closely. But as an avid student of financial history, we are also reminded not to have too much faith in human greed.
Further, margin trades done on lower interest rates via the Connect Schemes have strong motive to persist due to the interest spread and the prospects of handsome gains. And these funds will likely continue to target the technology stocks and the ChiNext Board in Shenzhen that are benefiting from a re-rating spillover from the coming launch of the new tech board.
The presence of these leveraged trades will aggravate market volatility in the near term, and short-term traders will be shaken out of their positions, as long-term investors take over. The changing of guards between traders and investors will likely skew the risk-to -reward ratio as well in the near future. But we believe that long-term trend trumps short-term volatility.