2016: Year of the Circuit Breaker - January 6, 2016

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Greetings,

The implementation of exchange circuit breakers really picked up after the Flash Crash of 2010, when high frequency traders spun out of control. The idea is to give computers 15 minutes to recalibrate, creating a more orderly market. However, in China, where individuals drive more than 80% of trading volume, a 15 minute halt after a -5% decline really just gives investors extra time to place sell orders before the -7% threshold, where trading is stopped for the day, gets triggered. The Chinese circuit breakers were operational starting January 1 and were put to the test immediately.

Many pointed to weaker than expected December Chinese PMI data as the cause of this sell-off, but it’s more complicated than that. PMI has been weak for a while, and wasn’t much of a surprise. During June 2015, when the Shanghai Composite lost -35% of its value in three weeks, the Chinese government halted IPO issuance and restricted selling for large stakeholders. Over the holidays, those limitations were relaxed and January 4 was really the first day to see the market’s response. It reacted very poorly and now the government is back intervening, flooding the market with liquidity, and probably threatening short-sellers covertly.

Unlike in June, when developed markets largely ignored the Chinese meltdown, global equities struggled mightily on Monday. Japan’s Nikkei was -4% after two days of 2016, and the German DAX is down -4.5% YTD. Of course, there were other factors at play. Saudi Arabia and Iran are back to setting each other’s embassies on fire, December US PMI was the lowest it’s been since June 2009, and EU countries are closing down their borders again. Oil is still falling, yield curves are still flattening, and gold is starting to get a spring in its step.

But alas, China is really what’s moving the needle these days. Authorities are walking a fine line as they attempt to prevent market disorder without simply postponing an inevitable correction. It’s also a little alarming that Chinese stocks are so weak at a time when the Renminbi (CNY) is simultaneously declining. 1-Year CNY forwards are the weakest they’ve been since March 2009, which should go a long way towards supporting the country’s export and manufacturing sectors.

We keep hearing commentary that China’s slowdown is no reason to be bearish. That 5% GDP growth in China isn’t the end of the world, even though it was growing 10%+ in 2010. It’s simply a country transitioning from an export-driven model to one based around consumption. That analysis seems to ignore the fact that such a transition has never occurred seamlessly for any economy in history, let alone the world’s second-largest economy. An economy that is largely still figuring out how to deal with market forces. China has seemingly limitless potential for growth and consumption, but that doesn’t mean its financial markets for ready for the major leagues.

The Cup & Handle Fund is up around +0.5% YTD, and +6.0% Y/Y. It’s that time of year again when returns are reset zero. It’s always a little daunting to start all over again, but we’re confident in our positions and off to a decent start. We finished 2015 up around +6.5%. That’s fine, it beat the S&P 500 and all the hedge fund indices, but still seems like nothing to write home about. I’m getting back into the groove this week, and should have a monthly letter for January available shortly. If you’d like to start receiving these letters click here.

With that I give you this week's letter:

January 6, 2016

As always, if you have any questions or comments or just want to vent, please send me an email at mike@cup-handle.com.

Until next time, tread lightly out there,

Michael Lingenheld

Managing Editor – Cup & Handle Macro

Posted to Cup & Handle Macro Research on Jan 05, 2016 — 12:01 PM
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