Michael Pettis: China’s Stock Markets And Revisiting 2011 Predictions

China’s Stock Markets And Revisiting 2011 Predictions by Michael Pettis’ China Financial Market

I plan to post a new entry very soon but before doing so I wanted to say a few things about the stock markets, which continue to be insane (but not unexpectedly so) and then repost a blog entry that is nearly five years old. By the time I published my latest (July 17) blog entry Beijing had managed to stop the panic with the use of what I called “brute force”, by which I meant that there was never likely to be much impact from interest rate moves, regulatory changes, margin relaxation, and so on. This is because there had been such a remarkable convergence among investors, almost all of who were purely speculative, on how to interpret information, and because any interpretation was likely to be self-consciously skeptical, that any regulatory response had to be completely unambiguous.

There is nothing less ambiguous than actually buying or selling large amounts of shares. In a July 8 message to my clients, I argued that

… the only way to create a credible floor, or to create credible expectations of rising prices, is by “brute force”. Beijing must force entities under its control, or entities it can influence, to buy shares until all uncertainty is removed.

The panic could only be stopped, in other words, by very visibly forcing institutions under state control to buy heavily, and to prevent them from selling. Other forms of signaling would not work. This is indeed what the regulators did, and they did it powerfully enough that by July 9 they had arrested the panic and set the market off on another surge.

The problem with the surge was that the various “unorthodox” measures used to stop the panic created all sorts of strange convexities and implied options that could either interrupt or speed up the surge, and in a market in which there has been both a convergence of strategies and, what’s worse, a convergence in the way information is interpreted, any interruption in the surge was likely to be brutal. In this market, either we collectively agree that we have decided to buy, or we sell.

What worries me most is that many of the measures employed by the regulators to halt the panic are unorthodox enough, to put it mildly, that they can introduce all kinds of new convexities and implied options that we don’t fully understand. As we begin to recognize and understand them, however, these might be enough to undermine confidence in our widespread agreement about having reached a consensus.

There was one measure about which there is some disagreement as to its size and its importance, but this might be more than counterbalanced by the very simple and clear signal it gives:

I realize this is very abstract, but it might help make things a little clearer to consider one of the best-known of the measures employed over the desperate weekend of July 4-5. This measure is described in a recent article in Caixin, which describes a meeting held by the CSRC involving the heads of China’s 21 largest brokers: “The firms announced in a joint statement that to stabilize the stock market they would spend at least 120 billion yuan combined to buy exchange-traded funds linked to blue-chip stocks listed on the Shenzhen and Shanghai bourses. Moreover, the firms pledged to hold all stock that had been bought with their own money until the index reached at least 4,500 points.”

Why would this matter? Because if brokers are holding large amounts of shares that they are eager to sell, but cannot do so until the index hits 4,500, this creates a barrier, or at least a speed bump, at around 4,500 whose impact as the market races up is hard to determine. This acts effectively as a kind of call option that investors must give away any time they buy stocks while the index is below 4,500.

My worry, as I discussed with my clients, was that as the index approached 4,100 or higher, the threat of intense selling by capital-tight brokers at 4,500 meant that anyone buying shares was implicitly giving away a free call at 4,500, and the higher prices went, the less upside there was and the more downside.

Writing a synthetic put option

By the way remember that if you are long the underlying asset and short a call option, you are effectively short a synthetic put option struck at the same price as the call option. This means that anyone who owns shares might in fact be short a complex synthetic put option on the market. If the writer of the put can cancel the option at no cost, the rational thing for him to do would be to cancel it. In fact he can do so simply by closing out his long position and selling his shares. By the way the fact that most investors do not understand option theory is irrelevant. The option framework predicts how investors will behave as long as they understand that a lot of selling puts downward pressure on