China's Stock Market Crash Destroys Hope; Foreign Investors Dump ASHR at 10% Discount to NAV

China's stock market boom in 2015 is almost entirely liquidity fueled and it has almost nothing to do with the economy. Even if the Shanghai Composite crashes to 2500 and is still there in November, it will be up for the year. The long-term chart looks bullish.

Best sign of a potential bottom is the blowout in the ASHR ETF today, down 10%. The value of ASHR based on the 7/7 close is $40.90, but it's being sold at $37 right now, a discount to NAV of 9.5%.

If the only sign were the stock market, I would put more faith in my spidey sense. Concurrent signals are pointing in another direction, to revelation. People aren't panicking over China's stock market, they are panicking because they suddenly realize the bears might be right.

The bullish view was voiced by Stanley Druckenmiller who noted these type of bull markets are often preludes to economic recoveries. When the bull was going strong in May, Stanley Druckenmiller said:

The Chinese stock market is up, I don’t know, 140 percent in six months after being in a downtrend for five to seven years, and it’s doing so on record volume with record breadth. If it was any other stock market or certainly any developed market, I would tell you, being a market observer, there’s a 98 percent chance China will be in a cyclical boom 6 to 12 months from now. Because it’s China, and we don’t know the nature of what we’re dealing with here relative to normal mature developed markets, I would downgrade that assessment from 95 percent, but I would still hold it over ... I would point out that the H shares in Hong Kong representing China are 10.1 times earnings.

Housing data turned up in first-tier cities such as Shenzhen, Beijing and Shanghai, along with upper second-tier cities such as Wuhan and Xiamen, but overall housing remains in a downtrend with investment barely positive nationally and collapsing in many provinces.

The northeast of China, reliant on commodities production and heavy industry, is in a full blow recession if you believe GDP growth is south of 4%-5%. This is the center of the economic slowdown.

I made the case for a major slowdown in Liaoning Sounds Warning on Chinese Economy, based on the Austrian school's theory of how a recession proceeds through the stages of production in the econonmy. In the Austrian theory of the business cycle, artificially low interest rates cause entrepreneurs to over invest in capital goods (higher stages of production). This creates a boom in the economy, followed by a bust when interest rates rise and reveal the investments were not profitable. In an "Austrian recession" the higher stages of production, such as mining and manufacturing, slow first and consumer spending is the last to be affected. Even in developed Western economies with a large consumer sector, the business sector is far more volatile and gross output (GO), as opposed to GDP, is far more sensitive to changes in the economy. An investment-led recession in China isn't a hard sell, but even in the developed economies, manufacturing and investment are leading indicators.

Here's Gerard Jackson making the case for Austrian theory as an explanation for Australian economy in October 2008:

Let me make the logic of the AIG's [Australian Industry Group] own manufacturing statistics so clear that even Richardson and Ridout can grasp it. If consumption was really responsible for our economic slowdown then it is obvious that firms at the lowest stages of production, those closest to consumption, would have been the first to feel the impact of any slackening in consumer spending.

Instead we find that the higher stages of production -- as predicted by Austrian economic analysis -- started to contract before any fall off in consumer spending. In short, it is not consumer spending that is the driving force in the economy but aggregate business spending. The following Reserve Bank chart makes this fact abundantly clear.

If business spending were disaggregated we would also find that changes in spending in the higher stages of manufacturing becomes the real indicator of whether the economy is facing a recession. The AIG's own manufacturing figures therefore show that the country has been sinking into recession since at least June. And Rudd's sudden spending binge can doing nothing to stop it.

Leaving aside the details of theory, the Austrian model has predictive value. The consumer is the tail, manufacturing and investment are the dog.

Here's Jackson in 2008 discussing the U.S. economy: Why America will go into recession

If only that were so. It isn't consumer spending that we should be looking at but business spending. We have seen that manufacturing appears to be expanding. But this expansion is being accompanied by inflation. I believe the expansion the rise in prices are the result of Bernanke's loose monetary policy. At the moment the situation has the characteristics of the classic boom-bust cycle, meaning that indicators of recession will first appear in the higher stages of production rather than at the level of consumption.

What needs to be understood is that economics is a qualitative and not a quantitive discipline, meaning that mathematics cannot help to predict the timing of a recession. An Austrian economist can tell us that central bank policies have made recessions inevitable. He can do this because his analytical tools have shown him that money is not neutral and that forcing interest rates below their market level — which is what Bernanke is now doing — and expanding credit creates an unsustainable economic boom while creating malinvestments, investments that are not justified by genuine market conditions.

Anyone aware of these facts can only declare the inevitability of a bust but not the timing. However, once certain symptoms emerge, then we know that the bust is appearing on the horizon. One of those symptoms is not a stratospheric stock market — that is a boom symptom — but other symptoms that tend to be neglected because orthodox economics cannot account for them.

In China, the slowdown in the manufacturing sector is clear, with the largest slowdown at the highest stages of production: mining and raw materials such as cement and steel. Real estate investment has collapsed. The signs of an "Austrian" recession are visible.

At the top I said the stock market boom had almost nothing to do with the economy, and this is true if the stock market is a reflection of the economy. The boom is very much tied to the economy though, because it is a part of it. What explains the stock market boom? The government's policy easing did not flow into the real economy, but into the stock market. The bailout efforts failed to revive the economy and businesses are diverting capital into the equity market.

WSJ: Chinese Firms Put Cash to Work in Stocks

“Manufacturing is a very hard business these days,” said Mr. Dong, chairman of the company. “I want to make some money from the stock market and use the profits to restart my manufacturing business later, when the economy turns for the better.”

...According to the latest official data, profits earned by Chinese manufacturers rose 2.6% from a year earlier in April, a turnaround from a drop of 0.4% in the previous month. Yet nearly all of that increase—97%—came from securities investment income, data from the National Bureau of Statistics show. Excluding the investment income, China’s industrial profits were up 0.09%.

The opposite view is: Everyone freaking out about China's stock market crash is missing one thing

“Local investors see the stock market as a short-term place for profit-taking, not an indication of China’s well-being, and are far more confident in the Chinese authoritarian, state-capitalist system (and are certainly untroubled by its sustainability as a new, hybrid model),” Eurasia Group president Ian Bremmer wrote in a note on Monday.

“I met hundreds of Chinese from very different corners of the Chinese system, and encountered no sense of impending economic crisis,” he added.

There's never a sense of impending crisis until it's obvious. The place to look isn't all corners of the Chinese economy, but the higher stages of production and the major sectors such as real estate. Do steel mills, coal mines and real estate developers have a sense of impending crisis or is a crisis already underway?

Going back to the stock market crash, where's the broader impact? Commodities such as oil, copper and coal. The tumble in crude oil has the tightest fit with the sell-off in China. Dr. Copper fell to a new post-2008 low today. The Australian dollar is at a new 52-week low today too.

China's stock market boom may not have helped the economy and the bust may not hurt it, but the boom and bust caused people to adjust their expectations and that will have a real impact on the global economy. This could be the capitulation bottom, or it could be a new phase of the U.S. dollar rally and commodities bear market. Elsewhere today, the Atlanta Federal Reserve hiked their GDP Now second quarter forecast to 2.3 percent.

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