Rules for investing in Chinese companies listed on the Hong Kong Stock Exchange were recently eased for investors within China. The change triggered a round of buying in ETFs that track the Chinese market.
However, this parabolic rally is probably not a great thing for many Chinese companies that aren’t listed on that exchange, like Alibaba (BABA), which gets little of the benefit of the rally but are at risk of being found guilty by association if the bubble pops.
There are some structural problems in the Hong Kong Stock Exchange. First, the rush of new buying demand isn’t fundamentals-based, but is driven by a “fear-of-missing-out” buying frenzy. If it is a bubble (and we think it is), then it’s not the worst we have ever seen, but it does present certain risks that could cause even more problems for those Chinese companies that aren’t participating in the current trend.
The second big issue with the Hong Kong Stock Exchange is its potentially destructive relationship with the Chinese government. Unlike other markets, an IPO in China has to be selected by officials in the government. However, the government has mandated that IPO valuations have to be kept artificially low, so investors clamor for IPO shares that are sure to rise to their intrinsic value.
Over the next few weeks, there are 44 IPOs scheduled for the Chinese markets. Historically, IPOs are significantly oversubscribed, which has turned on a massive capital vacuum that is sucking a lot of money out of the market. If buyers are chasing the bulge of IPOs and not continuing to support the bubble in already-public Chinese equities, the risk of a decline becomes much more significant.
BABA Has Less Upside, But All the Risk of Other Chinese Stocks
So why does this matter for companies like BABA? The stock isn’t listed on the Hong Kong Stock Exchange. The company opted to go public in New York, and Hong Kong’s rules won’t allow a dual listing like that. Although it seems like BABA should be somewhat insulated from potential instability in China, the risks are probably compounded by investors who don’t see a difference between Chinese companies listed in Hong Kong and those in New York.
BABA hasn’t enjoyed much of a lift from the Hong Kong rally, and so it has become the relative-strength loser in that geographic sector. When the eventual decline for Chinese stocks comes, BABA’s losses will likely be compounded by traders rebalancing their Asia exposure away from those that have been lower performers.
As you can see in the next chart, BABA’s performance has been almost directly opposite of the index of Hong Kong listed issues tracked by the iShares China ETF (FXI).
As Hong Kong-listed shares have been rounding over and finally selling off on May 5, BABA recently broke support and has accelerated its underperformance. This is particularly problematic for Alibaba stock because of the recent round of poor fundamental reports.
Alibaba Stock Plagued by Internal Issues
At the end of April, BABA’s chief executive, Jack Ma, announced that the company would not be expanding its workforce this year because of growth worries.
In addition, the Chinese government is investigating issues with “brushing,” which occurs when a vendor on Alibaba uses fake buyers to inflate sales, provide strong reviews and get a better ranking amongst the other vendors. It is estimated that 17% of BABA’s vendors use brushing techniques.
The January earnings report set a negative tone for the end of the lockup period. Not because growth was negative, but that it was lower than expected. Not even a strong dollar (a good thing in BABA’s case) has changed expectations for Alibaba stock so far this year. Considering the lack of core improvement in the Chinese economic reports this week (including the dismal PMI report last Sunday), the downside risk for Chinese stocks seems to be rising.
Combined with the risk of broader selling in Chinese stocks, we think BABA is poised for a very negative reaction to the May 7 earnings report. Earnings reports are always full of surprises, so there is no way to say for sure. However, this seems like a situation where the outcome from a negative report is much larger than the possible gains if growth exceeds expectations.
If Alibaba stock misses earnings and Chinese stocks continue to fall, the reaction should be even more profound.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
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