CHINA SPECIAL – Stock Market Crash, Slowing Growth: Is the Worst Behind Us?
Here’s How Option Sellers can Capitalize
July brought plenty of news for the markets in both stocks and commodities. It has shaken a few up. It has also brought some volatility into some of the option arenas.
Make no mistake, this is a good thing for option sellers. But deciding how to use that volatility to your advantage is another matter. That’s what we’re here to help with.
Greece and Iran were both big stories in July. Both situations resulted in deals. And while the ramifications of those deals could be felt in the market for years to come, the immediate impact may be somewhat muted as the stories fade from the front page.
CHINESE ANNUAL GROWTH RATE HERE
Caption: China GDP Growth in Decline. Is a rebound in the cards?
With Greece out of the headlines (for now), commodities investors may begin turning their attention to China. As the world’s second largest economy and a main driver of global growth (China has accounted for roughly 1/3 of global growth in the last four years), changes in Chinese demand can have a massive impact on global commodities prices.
In this special “macro” piece for commodity option sellers, we’re going to highlight for you what has happened in China, what is likely (and unlikely) to happen in the coming months and how it could affect commodities prices.
What Happened in China?
For China, the world’s second largest economy (US $10,380 billion GDP in 2014) has seen a growth rate steadily slow to 7.5% in 2014 – roughly have of the growth rate in 2007. That growth rate falling to 7% in Q1 2015 had many analyst calling for a “hard landing” in 2015-2016 for China’s economy. Indeed, Chinese imports of industrial commodities have halved in value over the past year, causing prices of many industrial commodities to plummet (see copper chart below)
December 2015 Copper
Copper prices have plummeted in the past year on the back of sagging Chinese demand. Copper prices are often used as a guage of overall demand for industrial commodities.
All of this before the big story of the summer – the “crash” of the Chinese stock market. It has garnered much investor and media attention – as it should. China’s market fell by 30% in just 5 weeks over June and July. It appeared the chickens came home to roost on overleveraged Chinese investors piling into an over-heated market at the encouragement of government.
The question is, have one or both of these trends run their course or is there more to come? If so, what effect will it have on hard asset prices (as a whole) in moving forward?
What Happens Now?
Unlike many investment firms or newsletters, it is not our purpose here to try to predict the future. As an option seller, you don’t need to do that. As an option seller, you only need to select a least likely scenario and then position yourself to potentially profit from every other scenario but that one. That is what we do – and thus will approach China analyses the same way.
Stock Market Crash – The fear has been that a collapse in China’s stock market could spread to other countries, such as US Stocks. That hasn’t happened – primarily because China’s equity devaluation was a process of an over-heated, over leveraged asset class coming back to earth. Furthermore, the Chinese financial system is much less integrated into the global financial system that say a Europe or Japan. Lastly, while values did fall 30% the market is still up an amazing 80% since this time last year. The term “crash” is relative.
The other fear was that a collapse in stocks was a precursor to a collapse in the Chinese economy. This is unlikely as performance of Chinese stocks has had little correlation to growth of the economy in the past. China’s stock market represents only 40% of the Chinese economy and only about 20% of Chinese citizens can afford to participate at all.
What happens next? Another leg down, potentially putting a fresh scare into global markets? Stabilization and or consolidation as most of the “dead wood” has been burned out? Or a rapid recovery back to or exceeding 2015 highs?
It’s a bettors choice but our view for the least likely is the latter. The Shanghai Composite has shown signs of stabilization. But Chinese investors (many new to the markets) have learned a painful lesson about bubbles and leverage and will not be eager to pile back into stocks – at least over the near term.
Chinese Economy – It is no secret that China’s economy was slowing even before the stock market event. But despite some economist projections of Chinese growth slowing to 6.5 to 6.8% in Q2 2015, July figures confirmed growth rate held steady at 7% (y/y last quarter), likely on the back of aggressive government stimulus.
Least Likely Scenario
What happens next? Another sharp lurch lower in projected 2015 growth? A spending halt by Chinese consumers, wary of a potentially unstable financial market, drawing down growth projects for 2016? A slow, gradual recovery as massive Chinese stimulus continues to kick in in the 3rd and 4th quarters. A rapid and unexpected recovery over the next 90 days as the public shrugs off the market crash – surging Chinese imports again.
Again, gamblers choice. However, in our opinion, the least likely scenario is the last. Q2 GDP seems to suggest that China’s economy may indeed be in for a “soft landing” after all. But we suspect much of the strength was a result of a brisk pick up in the financial sector as brokerages traded at a frantic pace in a lead up to the price crash. But other data seems to indicate stimulus taking hold. Industrial output expanded at 6.8% y/y, up from 6.1% in May. Fixed asset investment grew at 11.4% during the first half of the year.
Imports of raw commodities have begun to tick up in the last two months as well, leading some to believe industrial commodities are poised to spring rapidly higher into 2016. We think this type of thinking is flawed. The price levels of the last several years in products like tin, zinc, copper and cement was, in our opinion, a classic bubble, supported at artificially high price levels from government programs to build new cities. There are as many as 27 brand new cities now sitting virtually empty in China as a result of this effort.
While any scenario is possible, stabilization followed by slow but steady growth may indeed be the path for China now. However, we feel the least likely result is a rapid and sustained rebound in Chinese (and thus global) demand for Industrial commodities. That ship has sailed and the frenetic pace of construction that fueled the last rally in industrial commodities will not be present this time around.
Other Global Factors
Investors must also be careful not to view Chinese demand in a bubble. There are many other factors that go into price discovery of industrial commodities.
A re-ignition of the Greek/Euro crisis in the months ahead could very well outweigh Chinese demand when it comes to factors influencing commodities. Don’t rule it out. When I was a kid growing up in Wisconsin, there was a brush fire in the woods near my house. The volunteer fire department came out and put it out. 3 hours later they were called back. They put it out again. I went to bed. At 3:00 in the morning, I heard fire trucks roaring up the hill again. It kind of reminds me of Greece. The visible flames may have been tamped down for now. But the embers still smolder. Stay tuned.
How High Net Worth Investors can Play China in 2015
Bulls, encouraged by the latest GDP figures, will be tempted to begin bidding up prices of metals, building supplies and even oil in the coming weeks and months with the thought that a return to the glory days is ahead. We think any such rallies will be limited in scope. Therefore, a big picture strategy for Q3 and potentially Q4 2015 could be call selling in in industrial markets, despite current low prices. This outlook is not because we think prices will necessarily move lower but simply because we feel China is in a position to provide the horse power (as it has in the past) to drive prices substantially higher in the short term. This strategy will likely reward the investor in the event of another leg lower in the Chinese Stock Market or Economy (or an interconnected move in both), or a gradual recovery in one or both.
….a big picture strategy for Q3 and potentially Q4 2015 could be call selling in in industrial markets.
It’s a big picture strategy that can likely be employed across a variety of (but not all) commodities markets in the coming months. We’ve already outlined a strategy for this in crude oil (See Game Changer in Crude Oil from 7/13/15 on the blog) but will be exploring other potential markets for our private client group this month. Seeking out such markets yourself could be a profitable exercise if you’re trading these markets on your own.
If you are a high net worth investor interested in selling options in crude oil and other commodities, you may qualify for a managed option selling account with OptionSellers.com. To learn more, request your Free Investor Discovery Kit at www.OptionSellers.com/Discovery ($250,000 minimum investment.)
James Cordier is the author of McGraw-Hills The Complete Guide to Option Selling, 1st, 2nd and 3rd Editions. He is also founder and president of OptionSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television, Fox News and CNBC. Michael Gross is director of Research at OptionSellers.com. His published research articles have appeared on Forbes.com, MarketWatch, Optionetics.com, Businessweek.com and Yahoo Finance.
*Price Chart Courtesy of CQG, Inc.
Fundamental Charts courtesy of The Hightower Report
Seasonal Chart courtesy of Moore Research, Inc
***The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.