Bizarro Market or Not? Baosteel Is World's Largest Steel Company By Market Cap

One of the important things to understand about the market is that it is always "right" even if it is frequently wrong. The market reflects the aggregate thoughts of the investing public, which is weighted towards the "smart money" as they have more votes (dollars) in the process. When the market behaves in a way that is contrary to your expectations, a very big red flag must go up. Either your expectations are wrong or there is something affecting the market that you haven't unaccounted for. Psychology is one important factor sometimes overlooked. In other cases, economic or financial assumptions may be flawed.

During the housing bubble and the technology bubble before it, there were bears who pointed out the market would fall, but most also wisely said you don't short a psychologically driven market. Bulls incorrectly argued there was a "new normal" or that "home prices don't fall nationally." In the run-up to hyperinflation in Wiemar Germany, the public believed the economy was booming. The stock market rally was seen as proof of the economic boom, not incipient hyperinflation.

Today, here is ZeroHedge trying to make the case for corporate buybacks as one of the few things levitating the U.S. equity market: The US Equity Bubble Depends On Corporate Buybacks; Here's The Proof.

In 2013, responding to confusion about the plunging gold price, I argued the gold market was wrong back in 2011: Gold Lied, Inflation Died. I had a few trade ideas based on my deflationary thesis:

PowerShares DB Base Metals Double Short (NYSEARCA:BOM). Volume is very low now, but it peaks when base metals tumble.

For China, short iShares FTSE/Xinhua China 25 (NYSEARCA:FXI) and be long Global X China Consumer (NYSEARCA:CHIQ).

Emerging markets should underperform Europe, since Europe has already seen several major markets decline. ProShares Short Emerging Markets (NYSEARCA:EUM) is one way to go.

Resource exporting countries and companies will likely be hit hardest: they are threatened by a stronger dollar or weaker commodity demand. Brazil and Australia are two countries to underweight or avoid. Companies without sufficient capital to fund their operations will likely go bankrupt, and many commodity producers and explorers could go bust if they have insufficient capital heading into a crisis.

More conservative plays: iShares Barclays 1-3 Year Treasury (NYSEARCA:SHY), iShares Barclays Short Treasury (NYSEARCA:SHV), PowerShares DB U.S. Dollar Index Bullish Fund (NYSEARCA:UUP), ProShares UltraShort Euro (NYSEARCA:EUO).

Most of those picks were spot on. Brazil tumbled, the euro slumped, the dollar rallied. The worst pick by far was the CHIQ long, FXI short:

As I wrote then:

Gold is not alone in signaling weakness: nearly all commodities are sending a similar signal. On top of this deflationary force, the Chinese leadership appears ready to rebalance the economy towards the consumer sector, something that will dry up demand for many raw materials. Copper faces a far darker future than gold.

So what happened? Why did China's consumer sector go nowhere? Consumer stocks such as Want Want (0151) and Tingyi (0322) are well below their 52-week highs. A mitigating factor is that these stocks are in Hong Kong, but the Chinese herd hasn't caught on to these stocks at the very least because neither experienced "the pop."

Not only did consumer stocks fail to rally, but some of the sectors still suffering from overcapacity have outperformed the A-share market. Cement has done well considering, but steel has really outperformed. China's is currently puking steel because domestic demand is moribund. The performance of the global steel industry and suppliers has been poor:

Yet while SLX is down 20%, Chinese steel companies have double and tripled:

Bloomberg: China’s Baoshan Catches Nippon Steel as Most-Valuable Producer

“Baoshan has an edge over steelmakers in Japan where auto production won’t grow at a pace seen in China,” said Yoku Ihara, who runs Japan’s Growth & Value Stock Research. Baoshan is one of the few Chinese producers that can supply high-end sheets to automakers, making it the “best positioned among so many Chinese suppliers, most of which make construction steel,” he said.

The China Association of Automobile Manufacturers projects domestic vehicle sales to increase an average of 5 percent to 10 percent a year, with sales last year of 23.5 million units. Japan’s new-car sales rose 3.5 percent to 5.6 million units in 2014, data compiled by Bloomberg show.

FT: Steelmakers braced for China slowdown

On Monday, The World Steel Association, the industry’s main international body, said it expected global steel demand to be largely flat in 2015, at about 1.54bn tonnes. Demand growth will then increase slightly next year, to 1.4 per cent.

“We are releasing a restrained growth outlook for the global steel industry mainly due to the deceleration in China,” said Hans Jürgen Kerkhoff, chairman of WSA’s economics committee.

My default assumption is the Chinese stock market rally has been indiscriminate or that the rally may be a precursor to currency devaluation. Stanley Druckenmiller has voiced the next best explanation China Stock Gains Signal Economic Recovery.

Steel Collapse

China's steel industry is moving towards a trough. Last year, Steel Trade Lawsuits Explode; Banks' Unceasing Nightmare; Defendants Flee set the tone for a year with rising NPLs in the steel sector. Recently, charges of corruption have rocked the industry:

China Baosteel executive under investigation for corruption

A top executive of China's Baosteel Group, the parent of Baoshan Iron & Steel (600019.SS), is being investigated for "serious disciplinary violations", China's corruption watchdog said on Tuesday, as Beijing intensifies its war on deep-seated graft.

China's steel industry comes under the anti-corruption spotlight

A Deputy General Manager [Sun Wendong] at Wuhan Iron and Steel Co. has been detained on suspicion of accepting bribes, according to an announcement made by the listed firm to the Shanghai stock exchange yesterday evening.

...The steel industry has been one of the areas targeted with close to ten steel executives investigated since last year, according to a report in today's Beijing News.

Anti-corruption teams are stationed in the steel industry for two months, scheduled to finish at the end of April. Insiders were surprised at the two arrests because the men were widely considered low key, capable managers, with the WISCO executive pegged as a potential future CEO.

Corruption charges are the least of the industry's worries as rising debt levels indicate business conditions are worsening. An undercurrent of default is raging as short term debt hit recently hit ￥980 billion, or 74% of the industry's ￥1.33 trillion in bank loans.

Previous government efforts to rescue the industry have failed. Reorganizations were supposed to help, but local governments each have an incentive to fight for their local mills and the central government fears economic instability. One proposed restructuring that would merge WISCO and Liuzhou Steel is 10 years in the making. An "Action Plan" was put together in 2012 that would allow the market to play a decisive role in allocating resources, strengthen the position of companies in the industry and create a competitive environment.

The 2012 Action Plan wasn't only for steel. The government was to halt approval of iron, aluminum, cement, plate glass and other industrial projects. For steel, the government wanted to leave about 300 companies. This number confused the public, since the market was supposed to be playing a role. Why did the government delineate the number of desired firms? The number comes from a government study which found 300 firms is appropriate during "normal conditions." The 300 firms accounted for about 90% of China's steel production.

The reason for the government's failure to tame the steel industry became crystal clear in 2014, when credit guarantees became a major issue. As with other industries, mutual credit guarantees form a web of interlocking liability. If one steel mill is shuttered, it sets off a chain reaction that shutters several more. In March 2014, Haixin Steel ceased operations with ￥20 billion in debt owed to 33 different lenders. Disaster fell on other steel and energy companies that had guaranteed Haixin's debt. This daisy chain of mutual guarantees tied the government's hands, restricting their actions for fear of setting off more bankruptcies.

If ￥20 billion can wreak havoc on the industry, imagine the problem facing the government today. In addition to the ￥1.3 trillion in bank loans, much of it short term, the industry's top 80 firms also owe ￥1.7 trillion in short-term high interest loans. Firms are borrowing to repay old debt, for instance a Xinjian unit of Baosteel saw its short-term debt climb 13.3% last year, even as long-term debt fell 29%. This increases the risk of default should credit conditions tighten.

Amid this looming chaos, a new three-year action plan is being developed for steel, plus a new 5-year plan and long-term industrial policies. If the government failed when debt levels were much lower and the economy was growing much faster, what are the odds of success today?

EEO: 钢的“底”

Chinese steel market still in decline

In a post from early December, Chinese steel industry profit margins collapse, I covered the collapsing margins at steelmakers. Now earnings are coming through.
China steel maker Baoshan's profits fall

China's Baoshan Iron and Steel Co said its annual net profit for 2011 fell by around 43 percent, as the nation's industry is hit by a slowdown in the domestic and global economy. Unaudited net profits fell to 7.3 billion yuan ($1.2 billion) in 2011 from 12.89 billion yuan in 2010, Baoshan -- the listed unit of China's second largest steel maker Baosteel Group -- said in a statement issued at the weekend.

The firm gave no reason for the fall in profit but it has previously said weaker demand and surging raw material costs eroded earnings in the first half of last year.

For resource investors, consider this delta: BHP Sees Another Record in Iron-Ore Output

BHP Billiton Ltd. said Wednesday it was set for another record year of iron-ore production after bumper output in the most recent quarter as it continues to expand operations in Western Australia's arid Pilbara region.

BHP's optimism over demand for its primary earnings driver helps damp predictions of a slowdown in industrial development in China, the world's biggest consumer of iron ore and other minerals. Anglo-Australian rival Rio Tinto PLC a day earlier posted record iron-ore output in the recent quarter as it too invests billions of dollars in mines and ports.

Finally, in early December I posted this chart of steel prices in China:

Here's an updated chart. Prices haven't been collapsing, but they've been ticking down at a regular price value, meaning the percentage losses are picking up.

Baosteel (600019.SS) stock has already priced in the decline and the stock has even bounced a little in 2012.

Chinese steel industry profit margins collapse

Hugh Hendry coined the "Confucian" aphorism, "Wise man not invest in overcapacity."

Chinese steel industry profit margins hits a historic low, 0.47% profit margin far below interest rates 钢企利润率创历史新低 0.47%利润率远低于利率水平 October profits fell 82% from September. Inventories are up 20-30% over the start of the year. Steel industry debt ratio is 67% and most of the debt is in the form of bank loans. Banks currently pay 3.50% interest on one-year deposits. Since steel is considered a fundamental industry for infrastructure and national development, bank loans have not been restricted and fixed asset investment in mining grew 17.4% over last year, while smelting and rolling fixed asset investment grew 18.9%.

Below is the Baoshan Compostite Steel Price Index, based on contracted prices. The first chart shows the drop in 2008, the second is the recent price decline.

Here's a short English article covering the news: Chinese steelmakers see profits plunge

Baosteel Deflation—宝钢通货紧缩

In September, Baosteel cut October prices. (宝钢下调10月钢价)
In October, Baosteel is cutting November prices:

Baosteel Group, the parent of Baoshan Iron & Steel Co., cut its prices of steel products for November delivery by 250 to 500 yuan per ton from October, a company official told Caijing on Oct. 12.

The country's biggest steelmaker cut medium steel plate prices by 400 yuan per ton, and cut the price of cold and hot rolled steel by 400 to 500 yuan a ton, the official said.

The special 100 to 300 yuan discounts on hot and cold steel plate for October orders was extended.

宝钢11月碳钢出厂价格继续下调

10月10日，宝钢出台钢产品11月新价格政策。在10月价格基础上，中厚板价格普遍下调400元/吨；热轧品种中普碳钢价格下调400元/吨，机械用钢等品种钢价格下调500元/吨，增加优惠100元/吨；酸洗价格下调250元/吨，增加优惠300元/吨；冷轧及热镀锌的价格普遍下调400元/吨，同时分别增加优惠300元/吨和200元/吨。其中，普碳钢和酸洗的价格是继10月下调之后继续深调。

通货紧缩.

Baosteel cuts October prices

Deflation?

Baosteel said hot-rolled carbon product prices were cut by 300 yuan a ton, with hot-rolled low-carbon products falling by 200 yuan and, and cold-rolled prepainted steel sheet down 350 yuan.

Steel plate and most cold-rolled products remained unchanged, traders who work with Baosteel told Caijing.

Hu Yanping, an analyst from consultancy Umetal, told Caijing that the price cut reflects growing competition in the hot-rolled steel segment which is used mostly by the machinery industry, a sector which has not yet fully recovered from the economic downturn.

The company raised prices for three consecutive months beginning June.

However, the market has been on a downward slide since early August. The MySpic Index, consultant Mysteel's weekly monitor of domestic steel prices, fell from 165 on Aug. 7 to 134 on Sept. 4.

Mysteel analyst Xu Xiangchun said Baosteel still has room to cut prices further, as its prices are still far higher than the average market rate.

通货紧缩?宝钢下调10月钢价

《财经》记者从宝钢贸易商处获悉，9月7日，宝钢出台2009年10月碳钢产品出厂价格政策，在9月价格基础上，热轧品种中普碳钢下调300元/吨；低碳钢下调200元/吨；热轧酸洗下调300元/吨；彩涂普遍下调350元/吨；冷轧、热镀锌、电镀锌、镀铝锌、电工钢以及宽厚板的价格维持不变。