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China Bears Who Foresaw The Crash Are Back With Record ETF Short
Perspective | 02 December 2015

US short sellers are piling on bets against Chinese equities at the fastest pace since the height of the nation’s stock-market bubble five months ago.

Short interest in the largest US exchange-traded fund (ETF) tracking domestic Chinese stocks more than doubled in two weeks to a record 28 percent of shares outstanding on 27 November, according to data compiled by Markit and Bloomberg.

When such wagers last climbed this fast in June, short sellers proved prescient as China’s equity-market boom turned into a US$5 trillion rout.

After a 25 percent rebound in the Shanghai Composite index from its post-crash low through mid-November, pessimists are once again betting that the rally is unjustified as corporate profits shrink and the government dials back an unprecedented campaign to prop up share prices.

The bearish wagers are already starting to pay off after a selloff on 27 November sent the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF down more than 7 percent to the lowest level in three weeks.

“Sentiment is still obviously fragile,” said Tony Hann, who helps oversee about US$270 million as the head of equities at Blackfriars Asset Management in London. “The market is not cheap and the macro backdrop remains challenging.”

While Chinese equity valuations have fallen from their June highs, the Shanghai Composite index still trades at 13 times estimated profits for the next 12 months, a 30 percent premium versus its five-year average, according to data compiled by Bloomberg. Earnings have trailed analyst projections at a majority of index companies for eight straight quarters.

Profit Decline
There are few signs of a recovery as growth in Asia’s largest economy slows. Profits at Chinese industrial companies dropped 4.6 percent in October, official data showed, while some of the earliest economic indicators for November signalled a deterioration from the previous month. China’s manufacturing conditions slipped to the weakest level in more than three years in November, data showed.

“Some investors believe China is only at the initial stage of a slowdown in its economy that will affect a slew of companies,” said Robbert van Batenburg, a New York-based director of market strategy at Societe Generale.

Short interest in the US-listed ETF may also be elevated in part because authorities introduced restrictions on bearish bets in mainland markets, prompting investors to look for offshore alternatives, according to Sandy Mehta, the chief executive officer of Hong Kong-based Value Investment Principals.

Bears Rewarded
China’s two main exchanges introduced measures in August that restrict short sellers’ ability to sell and buy back shares in a single day, while some of the nation’s biggest brokerages have stopped executing the trades for clients. Volume in China’s onshore futures market, ranked the world’s busiest as recently as July, dried up after a series of regulatory curbs meant to discourage bearish bets.

“I am sure local brokers are more hesitant to place short trades on behalf of clients, so people are trying to use ETFs and other vehicles,” Mehta said. “I don’t think the recent news from China will make them more bearish than where they were a month ago.”

ETF short sellers were rewarded five months ago after more than doubling their bearish wagers in the two weeks leading up to the peak in June. Short interest reached 15 percent of shares outstanding the day the market topped out on 12 June, a record at the time. The ETF and the Shanghai Composite both fell more than 40 percent in the subsequent crash, a selloff that was only halted after the government’s intervention.

Nervous Investors
While policy makers are right to want to pare back their support, investors are concerned the market isn’t strong enough to stand on its own, according to Tony Chu, a Hong Kong-based money manager at RS Investment Management, which oversees about US$18 billion.

Since 6 November, authorities have lifted a freeze on initial public offerings, raised margin requirements, banned the use of derivatives for financing stock trades and scrapped an order for securities firms to hold net-long positions. They have also expanded a probe into rule violations in the brokerage industry, a move that helped trigger a 5.5 percent plunge in the Shanghai Composite on 27 November, its biggest retreat since the depths of the rout in August.

“Authorities in China are trying to get ahead of themselves to normalise the market,” Chu said. “Overseas investors are nervous.”

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