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“The purpose of models is not to fit the data but to sharpen the questions.”

                             S. Karlin

FX Trading – The Sentiment Switch and Chinese stock market crash!
I noticed the Chinese stock market fell 5% last night—at least that’s what’s been reported by Bloomberg and others; I actually didn’t notice it really.  Was it JR’s Currency Currents of yesterday talking of China coming “unhinged” that did the trick?  Doubtful, but his views are part of that interconnected and complex hierarchical web we call sentiment. 

We’ve been talking about China for a while now, as you know.  We see China through a skeptical lens.  And though we’d love to say—yes, we called it right on the button (assuming China does come unhinged; still a big assumption), we can’t.  But the reality is that we have been worried about China for a while—and missed most of the big rally Chinese optimism generated.  But a change of view is in the air.

I make that point to make this point: Sentiment in markets seems to change with a flip of a switch.  Last week very few were talking about China, this week a whole bunch of people (high level types) are noticing and talking at the same time about the dangers of force feeding an economy that is hermetically sealed by capital controls and a fixed currency—it creates bubbles!

The market is created by real people moving real money; all based on their flawed view of the future.  Some people have a much greater impact than others i.e. those moving the most money have a greater impact; let’s call these people the higher level players—those on the top of the market food chain.  They run pension, private equity, and mutual funds.  But, there is always a feedback loop between these higher-level players and lower-level players in the market food chain.  It is a complex hierarchical relationship with fractal and power law dimensions.

These higher-level people, or “agents,” are waking to the idea China is bubble-icious.  Of course when these people notice, it becomes an original idea and noticed by the financial press, despite the fact that some lower level “agents” have been warning of the same dangers for a while.  The higher-level “agents” rarely dispel the notion their idea was original; which is why some are credited with calling market tops and bottoms when many around them have done the same.  Put another way: The rich get richer. 

The higher level “agents” by virtue of their status, are leaders to the lower level “agents” which then move their money accordingly. And sometimes it’s not hard to lead when a portion of the lower level “agents” have already been cognizant of the growing dangers. 

Thus, we get what appears to be a shift of sentiment on a dime as if someone just woke up one morning and flipped a switch. 

“The stock market is made of actors that differ in size by many orders of magnitudes, ranging from individuals to gigantic professional investors such as pension funds.  Structures at higher levels, such as currency influence spheres (US$, Euro, Yen,…), exist and with the current globalization and deregulation of the market one may argue that structures on the largest possible scale—that of the world economy—are beginning to form.  This means that the structure of the financial markets has features that resemble that of hierarchical systems with ‘agents’ on all levels of the market.  Of course, this does not imply that any strict hierarchical structure of the stock market exists.  However, critical phenomena induced by imitation forces in these conditions may often exhibit a rather nonintuitive phenomenon, called ‘log periodicity,” in which, for instance, the probability or the hazard rate are not monotonously accelerating but are decorated by oscillators with frequencies accelerating as the critical time is approached.”

                        Didier Sornette, Why Stock Markets Crash (Published 2003)

Sornette wrote his densely mathematical packed and fascinating book back in 2003.  I have referenced it before in the pages of Currency Currents, long time readers may remember.  But fast forwarded to today; Sornette and team recently made a very interesting prediction on the Chinese stock market, maybe off by only 2-days!

On July 10th 2009, Sorrnette and team wrote an article titled, “The Chinese Equity Bubble: Ready to Burst.”  They predicted a Chinese market crash would occur somewhere between July 17-27!  We have printed the first two paragraphs of the piece below, along with their chart, and linked the article so you can read it all for yourself:  

“In the light of a global downturn a wide range of stimuli packages and fiscal gifts have been launched by many governments of which China makes no exception. However, in China these actions might have lead to an unsustainable rise in asset prices, a so-called “bubble”. The Shanghai Composite is the best performing large stock market in 2009 and is up 65 per cent for the year, and rising. To reach a targeted GDP growth of 8%, Chinese policy has turned to a bank model of massive lending, which has provided China with sufficient liquidity to fuel this bubble. Talk of a China bubble is heard in the market, but when or even if it will collapse is unknown, as usual. Macroeconomic and other qualitative factors have been used as arguments for or against the hypothesis of a China asset bubble.

“We take a different approach here by closely examining the price changes of the index. This work is based on Didier Sornette’s group (in particular with Anders Johansen from 1995 to 2002, with Wei-Xing Zhou since 2002 and, since 2008, with the FCO group at ETH Zurich: who pioneered studies to identify bubbles and obtain estimates on likely “crash dates”, when rapid acceleration in asset prices becomes unsustainable, leading to a crash. Sornette’s group applied their theories to correctly identify bubbles and ranges of crash dates for the US Housing boom1 and the oil bubble in 20082, amongst others.”

Sentiment about China seems to be changing fast.  Stay tuned.