China Bears Rush to Short U.S. ETF at Record Pace as Rally Fades

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U.S. investors have never been so convinced that the rally in China’s mainland stocks is ending.

Short interest in the largest exchange-traded fund tracking yuan-denominated equities rose to a record 16 percent of shares outstanding Wednesday as bets on a price drop almost doubled from a month ago, according to data compiled by Markit and Bloomberg. Traders pulled $258 million from the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF last week, the most since the fund was created in 2013.

Bearish sentiment is spreading as the Shanghai Composite Index has gone from the world’s best-performing major benchmark following a year-long rally to the worst this week. The gauge of mainland stocks capped its biggest weekly drop since June 2008, sliding from a seven-year high. While bulls say China’s monetary easing will support further gains, bears see the market as unhinged from economic fundamentals.

The selloff “has further to go before it gets back to a much more rational trading pattern compared with this liquidity-induced bubble that they’re in right now,” Michael Mullaney, who helps manage $12 billion as chief investment officer at Fiduciary Trust Co. in Boston, said by phone Thursday. “Everything will always eventually come back to the macro economic backdrop for China, which is still slowing.”

Stock Bubble

Deutsche Bank AG’s A-share ETF fell 7.4 percent to $51.10 in New York during the four trading days through Thursday, mirroring the retreat in the Shanghai Composite. The Hong Kong-traded iShares FTSE A50 China Index ETF, the largest A-share fund globally, sank 7.9 percent during the same period to HK$14.92. Mainland stocks have more than doubled in the past year.

The Shanghai Composite slumped 6.4 percent at the close Friday, capping its biggest weekly loss in seven years. The $1.2 billion Deutsche A-share ETF fell 5.3 percent to a one-month low of $48.40 at 1:57 p.m. in New York.

This week’s retreat came as analysts projected that a flood of stock offerings will lock up the most funds since new share approvals resumed in January 2014.

More than half of 39 investors polled by Morgan Stanley this month said China’s mainland stock market is in a bubble and they expect an additional 10 percent correction over the next 12 months, the New York-based bank said in a report Thursday. Global investors “are the most bearish since we began the survey in March 2013,” analysts led by Brian Kelleher wrote.

The selloff is a healthy pause in a longer-term rally rather than the prelude to a market collapse, according to Charlie Wilson at Thornburg Investment Management Inc., who said he may use the retreat to add holdings of high-quality companies.

No Collapse

“Part of what’s driving the pullback is the regulators systematically trying to crack down and pulling out some of the hot air,” Wilson, who manages the $2 billion Thornburg Developing world Fund, said by phone from Santa Fe. “The last thing the government would like to see is a collapse. They try to manage the enthusiasm of the market but they also don’t want it completely deflated.”

His fund has gained 7.4 percent annually over the past five years, beating 96 percent of its peers.

The China Securities Regulatory Commission said last week that brokerages should limit margin trading and short selling at no more than four times their net capital. The Shanghai Composite dropped 6.5 percent on May 28 after brokerages tightened lending restrictions.

Mainland Chinese stocks on average trade at about 256 times reported earnings after shares surged 133 percent in Shanghai over the past year, data compiled by Bloomberg show.

“The implied price-to-earnings ratios are astronomical,” Mullaney said. The valuation measures “lead us to believe it’s very bubble-like right now.”

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