How China's Problems Can Deliver a 30% Gain in 3 Months

In the fall of 2016, I warned readers of my premium advisory, Profit Amplifier, of continued weakness in China and the subsequent fallout in its fragile stock market.

The Chinese market is ruled by twitchy individual investors. By late December, the iShares China Large-Cap ETF (NYSE: FXI) had fallen 12% to a key retracement level around $34. But the New Year has brought buyers back into the Asian markets and back to FXI. Shares have rallied nearly 8% from their recent lows, likely due to a massive short squeeze (which I will detail later). Yet despite the apparent bullishness, there have been no fundamental improvements.

In fact, I'm seeing quite the opposite.

China is a conundrum because deception reigns supreme. This is a country where a major construction company that defaulted on its bonds has delayed releasing its earnings for more than two years. It would be like Enron "hiding" its balance sheet manipulation for 26 months while it continued to scam the public.

Traditional measures of value don't work well in China because the earnings results of many Chinese companies are known to be padded, manipulated or "tunneled" through creative accounting. These things happen because business culture is very different in China, and the rules that we have here simply don't exist over there.

And because individuals -- not professional institutions -- are the largest holders of stocks, the market's movements are even more distorted. Market direction is dictated by events and emotions, rather than hard and fast fundamental earnings data.

With that in mind, I've found it effective to utilize warning signals in news and economic data to cue entries and exits in Chinese stocks as opposed to analyzing price-to-earnings (P/E) multiples, sales growth, etc. This has led my readers and I to several successful trades in the past. And right now, I see several warnings flashing for a bearish entry that should be enough to send FXI back toward its December lows -- enough for us to capture a potential 30% return.

Debt Bubbles, Trade Wars & Currency Manipulation

Economic trends have not improved the backdrop for Chinese stocks, and recent data and price action shows a market on the verge of a massive selloff. While China's President Xi Jinping assures the world the Chinese economy is just fine and dandy, top experts see no end to the declines in the Chinese yuan and the country's economy as debt swells, spending drops and domestic growth stalls.

China is fueling its slowing economy with massive amounts of debt to help "puff" its economic data, which some experts warn could lead to a "full-blown banking crisis" sooner rather than later as numbers balloon to levels that dwarf what we've seen before previous collapses.

At the end of 2016, The Bank for International Settlements cautioned the world of China's record "credit to GDP gap" of 30.1. This level is much higher than what we saw during East Asia's speculative boom in 1997 or the U.S. subprime bubble before the Great Recession.

And remember, China's not going to get kid gloves treatment from Trump, who has been very public about his disdain for trade imbalance. And if a trade war were to ensue, it could seriously hurt China's growth.

Chinese exports dropped in 2016, and a trade war hasn't even begun yet!

Even if Trump fails to really turn up the heat on China, the country is still likely to be in for some trade pains because Trump's administration is centered around equalizing trade with China and Mexico. According to Chinese data, the country's trade surplus was a massive $251 billion extra in exports in 2016 alone, down just $10 billion from 2015. For reference, the U.S. Treasury uses anything greater than a $20 billion trade surplus as one of its three criteria when naming a country as a currency manipulator.

And even though the decline in Chinese exports shows a weakening economy, China is still in a massive export surplus, meaning imports need to rise, or exports need to fall (and either would hurt Chinese growth).

In a rare appearance, President Xi attended the world economic forum, pleading for global trade to continue unimpeded. To me, that suggests he obviously knows the risks.

Faking Stability

China's debt-to-GDP ratio now stands at a record 250% -- more than double the typical emerging market economy, which averages around 125%.

But the biggest canary in the coalmine here has to do with something called "excess debt," which is, essentially, private sector debt (personal and business loans). According to wealth management bank Pictet, too much excess debt "has proved a reliable predictor of serious financial problems, as evidence shows economies tend to slump once excess debt reaches 10% of its GDP."

China's excess debt has been above 10% of its GDP since all the way back in 2012. Today, it currently accounts for more than 30% of the country's output.

That number is also likely to swell based on continued economic slowing and a new American administration bent on equalizing trade.

With a potential trade war looming, China could be in for a very rough 2017. Stocks are often one of the first things to respond to falling market outlooks, especially in a country like China, where nervous investors can dump stocks alarmingly fast.

Short Squeeze Sets The Entry

FXI is a very liquid ETF that tracks large Chinese stocks. It gives us general exposure to the markets over there and trades with very heavy volume, allowing easy entries and exits.

For reasons I've outlined, short interest in the Xinhua China 25 Index rose an unprecedented 50% in December. In other words, bearish pressure is building as investors are starting to see more of the writing on the wall for a China selloff. But one consequence of so much short interest is something called a "short squeeze," which is when a stock, ETF or index that's in a bearish pattern (like FXI), experiences a momentary, but sharp rally when short sellers take profits and trigger margin calls.

Short squeezes can be nasty bullish events, but typically dissipate quickly. The squeeze has lifted FXI back to resistance, which gives us a near-perfect entry for a bearish trade by using put options.

FXI chart

FXI remains firmly in a bearish trend as it continues its series of lower highs and lower lows. While there may be some small support at the 200-day moving average around $35.60, the index tends to favor pivot points and levels of support and resistance.

The first pivot support level comes right at $35. If shares hit that level, based on the details of our recent trade at Profit Amplifier, it will be enough to pocket a 30% gain in less than three months.

If you'd like to learn more about how put options allow you bet for or against stocks and ETFs while limiting your risk, then I invite you to check out this special report. I explain the basics of options, in addition to detailing how our strategy allows you to amplify your gains more than you would by simply buying or selling shares outright. To view the report, go here.

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