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How to Protect Yourself from China's Crashing Stock Market

Stock-Markets / Financial Crash Jul 28, 2015 - 07:24 PM GMT

By: ...

Stock-Markets

MoneyMorning.com Shah Gilani writes: Chinese stocks plummeted again yesterday.

The Shanghai Composite tanked 8.48% to 3,725.56, while the Shenzhen Composite fell 7% to 2,160.09. And the ChiNext, China's smaller equivalent of the Nasdaq, fell 7.4% to 2,683.45.

Based on everything the Chinese government and regulators have done to stem the sharp sell-off in Chinese shares and pump them back up, the unexpectedly big drop yesterday, on virtually no discernible bad news, could signal a serious crash ahead.


U.S. and international investors need to understand what's going on in China and position themselves to profit on a full-blown market crash there that could ignite global contagion…

The Sky Really Did Look Like the Limit

Chinese stocks were on a tear up to June 12, 2015. The Shanghai Composite soared 51% from the beginning of 2015 through June. It rose 134% in the past year. That meteoric rise was dwarfed by appreciation in the smaller Shenzhen index, which was up 173% over the past year, with a whopping 109% rise since the start of this year.

In spite of government cheerleading all the way up, spooked investors, for no good reason other than perhaps their own fear of heights and the economy's slowing growth trajectory, began selling in mid-June.

And sell they did…

The Shanghai Composite, the big Chinese benchmark index where China's biggest companies are listed, fell 32% in three weeks. From the market's peak on June 12 to the early July lows, companies listed across China's stock markets lost close to $4 trillion in value.

What looked like an uncontrollable freefall had to be met with government intervention; there was no other way to stem mounting losses caused by a negative feedback loop that happens when margin calls force market sell orders that push stocks down more, triggering further margin calls.

Master Manipulators Inflated Stocks… Then Had to Come to the Rescue

Frightened government officials and market regulators rushed to shore up the rapidly eroding banks of what had become the country's focus – soaring markets.

Government cheerleading from politicos, market regulators, and the Communist Party-controlled China Daily newspaper advocated stock ownership and touted the Shanghai Composite's rise above 4,000 as just the beginning of the bull market.

The cheerleading efforts were more than effective. Since the beginning of 2015, the China Securities Depository & Clearing Co. estimated new investors were opening up an average of 170,000 brokerage accounts a week.

The bad news turned out to be the new investors were mostly woefully undereducated speculators with no practical knowledge about stock trading or investing and a frighteningly large contingent of corporate executives who jumped into the markets with company capital, believing they could make more money riding the bull market than manufacturing goods in their slowing domestic economy and for a flat-lining global market.

If that wasn't bad enough, almost all the "new" investors employed huge amounts of leverage, buying stocks on margin.

By April 10, 2015, a month before the markets turned sour, margin reached a record $264 billion. But, again, that's not the worst of it. That margin calculation came from the China Securities Finance Corp., a government-controlled entity, under the watchful eye of China's market regulatory body, the China Securities Depository & Clearing Co.

No one has any idea how much other margin was extended to speculators through China's notorious shadow banking channels. Some analysts have estimated shadow margin lenders, charging above-market rates on loans backed by the value of inflated securities, could be equal to or higher than official margin loan calculations.

When the selling started, it created a cascade of sell orders, triggering a massive negative feedback loop.

"Do or Die" for Chinese Regulators

The government and regulators had to come to the rescue, or faith in China's young and evolving capital markets would be shattered.

First up, the People's Bank of China lowered interest rates. That didn't stem the selling. Then the central bank quadrupled the capital at the China Securities Finance Corp., because they were technically insolvent, and – more frighteningly – because the government wanted the company to extend more margin to securities holders so they didn't have to sell their falling shares. That didn't work.

Then the government abandoned what it hoped the world would see as its "free markets." Trading halts were imposed, and short sellers were threatened with criminal charges. And big holders of shares were forbidden from selling their shares for six months.

That all worked for three weeks. Markets bounced 16% higher, even though most stocks were halted and trading stocks were manipulated higher by government and private efforts. Apparently, that didn't work.

Yesterday's inexplicable drop on the heels of all attempts to put a floor under stocks (and manipulate them higher) was truly indicative of what free markets can do to central planning's "hopes and dreams."

A total of 1,500 shares, or half of all listed stocks that were trading yesterday, were halted when they hit the 10% down limit that triggers market "circuit-breakers."

If we were looking for proof that the markets are bigger than those who would manipulate them, we've got it now…

If the investing (or was that speculating?) public can't sell shares that are halted or meet margin requirements without selling more stock, and all attempts by the government fail to stem widespread panic selling, there will be a crash.

A devastating market crash in China would upend the Chinese economy and undoubtedly create a wave of contagion that could take stocks down across the globe.

Investors in the United States and elsewhere have been on tenterhooks lately from macro-global pressures and increasingly willing to take profits on the heels of the long U.S. bull market and now wobbling global markets.

Now is the time for all investors to make sure they have an exit plan to take profits off the table where they have them and to hedge any open positions they dare leave exposed. Buying put options on open positions is a worthwhile hedging strategy investors should immediately look into.

For those who believe a crash is near and is possible (if not probable), a lot of money can be made betting on falling stocks in China – and almost anywhere else.

My favorite Chinese fund to short in this case is iShares FTSE/Xinhua China 25 Index (ETF) (NYSE Arca: FXI).

There are numerous exchange-traded funds that investors can short and inverse funds investors can buy to profit from falling stocks. To get into position to short American markets when the time comes, consider these inverse funds:

To go short the Nasdaq, look at the ProShares Short QQQ (ETF) (NYSE Arca: PSQ).

For shorting the Dow, the play is ProShares Short Dow30 (ETF) (NYSE Arca: DOG).

And to bet against the S&P 500, look at ProShares Short S&P 500 (ETF) (NYSE Arca: SH).

If not now, when?

Source :http://moneymorning.com/2015/07/28/how-to-protect-yourself-from-chinas-crashing-stock-market/

Money Morning/The Money Map Report

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