This Bloomberg headline "If the Options Market Is Right, China's Stock Rescue Is Doomed" reads like something one would find in a tabloid, but the reverse is now true.
Options traders have never been so pessimistic on China’s stock market, betting the government’s renewed effort to prop up share prices is doomed to fail.Options Skew
The cost of bearish contracts on the China 50 exchange-traded fund surged to the highest level versus bullish ones since they started trading in Shanghai six months ago. The so-called skew also climbed to a record for a similar ETF in the U.S., even as government buying drove China’s benchmark index to a 10 percent rally in the final two days of last week.
Puts that pay out on a 10 percent drop in the China 50 ETF cost 7 points more on Friday than calls betting on a 10 percent gain, according to implied volatility data on one-month contracts. As recently as Aug. 24, the bullish contracts were more expensive. For the U.S.-listed Deutsche X-trackers Harvest CSI 300 China A-Shares ETF, the skew reached a record 38 points on Aug. 27 and closed the week at 28 points.
Puts that pay out on a 10 percent drop in the China 50 ETF cost 7 points more on Friday than calls betting on a 10 percent gain, according to implied volatility data on one-month contracts. As recently as Aug. 24, the bullish contracts were more expensive. For the U.S.-listed Deutsche X-trackers Harvest CSI 300 China A-Shares ETF, the skew reached a record 38 points on Aug. 27 and closed the week at 28 points.
Equities on mainland bourses traded at a median of 53 times reported earnings last week. That’s the most among the 10 largest markets and more than twice the 19 multiple for the Standard & Poor’s 500 Index. Analysts have cut their 2015 profit estimates for Shanghai Composite companies by 8.8 percent this year, according to data compiled by Bloomberg.
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Valuation Still Extreme
Fundamentally speaking, the Shanghai stock market is hugely overpriced. I concur with BofA strategist David Cui, who says equity valuations and earnings growth aren’t appealing enough to support the market in the absence of government buying.
Cui estimates the Shanghai Composite needs to fall another 35 percent before shares become attractive. “The government will not support the market forever.”
Sentiment vs. Valuation
Valuation aside, sentiment is extreme enough that a corrective rally could get going.
However, it's important to note that stock market crashes do not occur on overbought conditions but rather on oversold conditions when no one wants shares at even plunging prices.
Mike "Mish" Shedlock
