To The Moon

“The History of markets is one of overreaction in both directions.” – Peter Bernstein

Key Points:

- Record short volume and put buying will be fuel to violent technical reprieve.

- With the first Fed hike in sight, the HKMA’s less aggressive balance sheet trimming can help improve market visibility.

- Hong Kong is mired in deep allocation value. If without a US recession, the Hang Seng will recover swiftly; if not, then the Hang Seng can still have a technical reprieve before making a second low.

- Trade safe and good luck.

China released mysteriously strong economic activities data yesterday. But the US-listed Chinese stocks plunged another 10% on the previous night, bringing the total loss to close to 30% in three short days. Such capitulation in the US market rippled through to Hong Kong, a small open economy. The trading floor is rife with casualties.

The Hang Seng reversed most of its early morning loss after the surprisingly release, and the Hang Seng Tech (HSTECH) more than made up it. But it didn’t last. If the data were so strong during a normally weak seasonality of Chinese new year, why would the PBoC lower its CNY reference rate three days in a row? A weaker yuan tends to be a headwind for Chinese asset prices.

After the bloodbath, the market cap of the HSTECH, an index of 30 biggest Chinese tech companies listed in Hong Kong, is 1.14 trillion HKD. Amazon (AMZN) alone is 1.5 trillion USD. The market cap of Apple (AAPL) along is bigger than the entire MSCI China universe. Indeed, MSCI China has given back all of its cumulative return since its inception in the early 1990’s. And the drawdown on the Hang Seng is one of its worst since 1970.

Something is off.

We examine Hong Kong trading activities in details. We note that short volume has surged to one of its highest on record, together with the implied volatility of the HSI (Figure 1). Such high short interest is consistent with market anxiety. But note that such high short volume can occur during extreme market duress, and just before a cataclysm as a warning sign.

Given that the Hang Seng’s recent plunge is one of the worst in over five decades, we believe such high short volume suggests market capitulation, rather than an omen of what looms. Such intense short volume can be the fuel for violent market rebound, but will also take some time to dissipate given its sheer volume. At this juncture, patience is a virtue.

Figure 1: Short interest in Hong Kong surged to one of its highest on record

Source: Bloomberg, BOCOM Int’l

Meanwhile, put volume has surged to its highest on record – not surprisingly. We have only witnessed such intense put buying relative call for insurance just during the darkest hour of the pandemic in March 2020. Such option trading frenzy is consistent with the record short volume we plotted above. They both suggest extreme market pessimism. Such collapse in confidence will take time to heal, and will induce tremendous volatility as the market tries to find its bottom.

Figure 2: Put volume in HK surged to its highest on record, relative to call volume

Source: Bloomberg, BOCOM Int’l

With the Fed’s first rate hike after its epic easing in two days, the HKMA is busy preparing as well. The HKMA continues to trim its balance sheet, perhaps to steady the HKD in the face of a strengthening USD (Figure 3). Such precautionary moves from the monetary authority, while protecting the Hong Kong economy, are exerting undue pressure on the HSI as well. With the Fed’s first hike in sight, HKMA’s balance sheet move will be better anticipated, and such improved visibility will breathe some certainty in a nervous market.

Figure 3: The HKMA continued to trim its balance sheet ahead of the Fed

Source: Bloomberg, BOCOM Int’l

After this epic selloff, the Hang Seng is now mired in deep allocation value. Such extreme value only happens when the market is in deep distress, and/or there is a US recession. When the market was in deep distress without a US recession, the Hang Seng tended to recover swiftly, and such deep allocation value was consistent with market bottom. However, when a distressed market was seen with a US recession, which now appears increasingly likely, the Hang Seng would rebound from these levels, but make another low later. But either scenario, there should be a technical reprieve for now.

Figure 4: the Hang Seng is mired in deep allocation value

Source: Bloomberg, BOCOM Int’l

Conclusion

Our report titled “The Ides of March” this Monday (2022-03-15) alerted an impending dramatic selloff. Right now, record short volume and put buying suggest extreme pessimism and market capitulation, but technical reprieve tends to follow, fleeting or not. Such extreme cautionary trades for insurance purpose tends to be fuel for violent short covering rallies later. With the Fed’s first hike in sight since its epic easing, the HKMA’s move will be better understood and should help improve market uncertainty.

Hong Kong is now mired in deep allocation value. Historically, when deep allocation value was seen without a US recession, the Hang Seng tended to make a swift recover; but when with a US recession, the Hang Seng would rebound first but then make a second low. With the world on fire, we are in the later camp. Regardless, a technical reprieve should be in store.