How to Become a Vigilante Trader and Profit From the China Collapse Copyright ©2011 by Insiders Strategy Group LLC., Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 No part of this book may be reproduced, stored in a retrieval system, or transmitted in any form by any means, electronic, mechanical, photocopy, recording, or otherwise, without the written permission of the publisher, except for brief quotations in critical reviews or articles. NOTE TO OUR READERS: Insiders Strategy Group LLC or its editors and publications do not advocate the purchase or sale of any security or investment. Investments recommended in this publication should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company in question. Insiders Strategy Group LLC expressly forbids its writers from having a financial interest in any security that they recommend to their readers. Furthermore, all other employees and agents of Insiders Strategy Group LLC and its affiliate companies must wait 24 hours before following an initial recommendation published on the Internet, or 72 hours after a printed publication is mailed. How to Become a Vigilante Trader and Profit From the China Collapse The market is ruled by powerful forces. These forces often come into conflict with each other. One of the most powerful forces, as we have seen in recent years, is government intervention. Whereas the private sector has been described by Adam Smith as the “Invisible Hand,” others have contrasted that with the “Visible Fist” of government. Governments have the ability to manipulate markets — and alter outcomes dramatically — for extended periods of time. This is why Wall Street has expressions such as “Don’t Fight the Fed” — or on a more local level, “You Can’t Fight City Hall.” In financial terms, the Federal Reserve (aka “the Fed”) and the People’s Bank of China (PBOC) are two of the most dominating forces on the planet. Traders and investors cannot ignore their influence. But… these government heavyweights are not the most powerful forces in existence. Not even in the financial realm. There is an even more powerful force out there than the “Visible Fist” of government… and that is the force of nature. At the end of the day, nature is stronger than man. We ignore the forces of nature at our peril. We can see this in the various areas where human kind has tempted fate and lost: The Deepwater Horizon oil spill in the Gulf of Mexico. The Fukushima nuclear disaster in Japan. And so on. Man tries to control nature, and sometimes wrongly believes he has tamed it. The eventual result of this is a reminder just how small we are, in the form of nature’s wrath. This dynamic is very much at work in markets as well. We have seen no shortage of financial catastrophes and collapses in recent years, which can be compared to physical disasters. Once again, these disasters come about because man attempts to tame natural forces in unnatural ways — with pride and hubris leading to downfall. Markets are similar to oil rigs and nuclear reactors in that markets obey certain laws of financial physics. There are influences comparable to acceleration, inertia and gravity. (This is why we talk about the “velocity” of money, or overvalued markets “collapsing under their own weight.”) The laws of financial physics mean there are limitations to what one can safely build — just as in the real, physical world. If architects design a real-world skyscraper without the proper support structures and ability to withstand high winds, that building will eventually come crashing down. So too with flimsy or unsupported structures in the markets. Except market structures are different from real-world structures in at least one very important way. As observers such as Richard Bookstaber point out, financial engineers have a remarkable track record of failure that would never fly in the civil engineering world. 1 Just imagine if our actual, physical buildings and bridges had an alarming tendency to buckle up and collapse every five or six years. Imagine if the skyscraper your brother-in-law works in downtown had a 50/50 chance of simply toppling over in the near future. That kind of thing would not be acceptable. But for financial engineers in Wall Street and Washington, that kind of shoddy structure-building is more than acceptable — because insiders make money when the structures go up, and taxpayers foot the bill when they come crashing down. Government engineers are notoriously bad about building structures that eventually collapse. As with their Wall Street brethren, they do it over and over again without fail. All you have to do is study a hundred years of financial history to recognize this pattern. There is a reason why financial markets go through jarring crashes, plunges, and otherwise near-cataclysmic events in seemingly reliable cycles. Government intervention — and the tendency of politicians to try to please the public — has a lot to do with it. The goal of all politicians — be they American, Chinese, European, whomever — is to keep the “good times rolling” forever and ever. They never want a business downturn, let alone a recession. They never want hard times or benefits cut. They only want good news and good economic data, so as to keep the populace happy and win re-election. (Or, in the case of China’s leaders, to avoid dangerous civil unrest and the threat of revolution.) And so, politicians everywhere survive and thrive on this cycle of keeping the short term going. They further do this with an attitude Wall Street has dubbed “IBG-YBG,” which stands for “I’ll Be Gone, You’ll Be Gone.” IBG-YBG allows politicians and government leaders to make short-term decisions that improve the outlook now, in the present and near future, at expense to the medium and longer term. “Never put off until tomorrow what you can spend today,” and so on. And so: When we understand the motives of government, and further understand the wrath of nature, we can see why market downswings (and collapses) tend to be so violent. • As the market “booms,” both politicians and private sector leaders do what they can to keep the boom going as long as possible. • If markets were truly “free” and unmanipulated, you would have natural ups and downs as a part of the business cycle. But these ups and downs would be reasonably mild — not as wild on the upside, and not nearly as painful or destructive on the downside. • Without manipulation, economies would have to endure more regular episodes of downturn. The payoff, though, would be less destruction of wealth and a healthier economy overall as markets and businesses self-adjusted. • But, because the government’s goal is to avoid having ANY meaningful downturn, the highs (i.e. “good times”) are artificially propped up, which in turn encourages banks and businesses to expand too much, take on risky loans, and so on. • As politicians and business leaders try to suspend the normal laws of nature (which require occasional downturns), the pumped-up economy diverges farther and farther from reality. Eventually the forces of nature require a reckoning, in the same way that a poorly built skyscraper will eventually topple down. • The above mechanisms of artificial boom and follow-on bust have been perfected by Washington and Wall Street. But in the early 21st century, we see that China has adopted the manipulative “artificial boom” habits of the West — and implemented their manipulation on a huge scale. 2 Another way to understand this “man versus nature” phenomenon is through the metaphor of forest fires. In nature, forest fires occur on an occasional basis. This semi-regular occurrence of fires actually helps keep the forest healthy. How so? Because the fires clear up the small deposits of dead underbrush and dry growth that have built up on the forest floor, and also consume dead or dying trees. The occasional fire, in other words, is a cleansing process under normal circumstances. The healthier trees survive, vegetation comes back, thus allowing the forest to renew itself and grow from a stronger base. In contrast: When government (in concert with the private sector) attempts to stop economic downturns through artificial manipulation of the credit cycle, this is like zealous fire suppression by humans. When a forest does NOT get a cleansing fire for a long period of time, dry growth and underbrush tend to build up to dangerous levels. The ratio of dead or dying trees to healthy trees goes up, because the dead trees are not cleared away. The longer this goes on, the more the once-healthy forest transforms into a giant tinderbox. From that point on, it only takes a tiny spark to set everything ablaze — and a raging inferno, rather than a moderately controlled and cleansing fire, is the result. Again, this is man attempting to put artificial limits on the down part of the cycle. And nature responds by saying “Well, if you are going to limit my range of motion, then eventually my response will be much, much more vengeful — and powerful enough to overwhelm you.” China, specifically, is a frightening example of the above. China in recent years has NOT been a growth example in correspondence with healthy free market economics. Instead, China has been expanding based on direct orders from government authorities, with a mandate to maintain full employment (rather than make profits). By the forest fire metaphor, China’s suppression of “fire” (i.e. downturn) has led to an incredible build-up of dead wood and underbrush, subjecting China to the “inferno” risk of stalling growth even as inflation pressures rise. (At the time of this report, new data argued for China’s economic slowdown even as inflation pressures hit a three-year high.) So what does a vigilante trader do? • A vigilante trader watches and observes where man makes gross errors in his attempts to fight nature — through government policy, lack of respect for risk and so on — and then profits through trades that help bring the market “back to reality” and back in line with realistic expectations. • Or to put it in a simpler way: Vigilante trading is about anticipating a forced return to reality — the laws of nature winning out — and helping to bring about that result. The way to do this is to (1) observe the interplay of willful forces and nature, and then recall that (2) willful forces can win at first, but nature always wins in the end. Manipulative forces, complete with a willingness to pump up assets, can “prop things up” for an extended period of time. In fact, this type of manipulation can go on long enough for many who observe it to call it a “success.” And yet, bad ideas and policies must eventually be purged — and old debts settled — before the market can rise up in a healthy way again. Most market participants and politicians do not want to hear that. And so they fight tooth and nail to keep it from occurring. 3 So vigilante trading specifically is a discipline of waiting for prices to become too euphoric, overly hopeful, or otherwise out of whack, and then take advantage when reality asserts itself and the “price discovery” process leads to much lower values. A few pocket principles to remember: • Markets are an interplay of powerful forces: Man on one side and nature on the other. Man always seeks to “beat” nature, by extending the good times longer than is realistic. Nature always wins this contest in the end. • Humans are very stubborn and will continue to try and “push” things beyond all rational reason. Politicians do not give up easily. Nor do die-hard optimists and other market bulls. This means they will fight hard against any intrusion of “reality” that does not go their way. • Trading opportunities arise as a function of these forces (man fighting against nature). The vigilante trader has to be careful in recognizing that the bulls will not go easily. The best spots for entering positions thus often come after some kind of “hope jag” rally, or other period of temporary relief that allows prices to rise (only to get beaten down yet further). The coming China Collapse will be one of the largest and most destabilizing market events of the next few years. One simple and effective way to trade China’s collapse is via the ProSharesUltraShort FTSE/Xinhua China 25 (FXP:NYSE), or just “FXP” for short. As an inverse ETF, FXP is built to mirror the FTSE/Xinhua China 25 Index. When the China 25 Index goes down, FXP goes up twice as fast. The Xinhua China 25 Index consists of the largest and most liquid Chinese stocks on the Hong Kong stock exchange. The China 25 Index on the whole is heavily weighted toward financials. This is appropriate to the risks China faces, as the property development Ponzi schemes currently unfolding could hit financial institutions the hardest. There are questions of whether China will be able to “bail out” its banks in the event of a sudden collapse of various real estate bubbles around the country. After all, China has something on the order of $2 trillion in cash reserves, right? Can’t Beiing put that money where it wants? Historically, though, having huge cash reserves does not prevent a crash. Japan also had the equivalent of trillions in cash reserves in the late 1980s and early 1990s — and that did not prevent the Nikkei from crashing. The challenge is that (1) it is not always easy to move money around, especially large amounts, and (2) the liabilities of the banks could actually run into the trillions or more. It was recently reported by Moody’s, a large ratings agency, that local governments in China have racked up a solid half trillion worth of debts — far more than expected. And that is just an estimate, not including all the loans that have gone to private property development schemes. Point being, even China’s big cash hoard is not likely to save it from potential financial collapse when the time comes. The ProSharesUltraShort FTSE/Xinhua China 25 ETF (FXP:NYSE) is one way to take advantage quickly. Macro Trader is oriented to take advantage of this China collapse in the “vigilante trading” style by carefully monitoring events for key inflection points; looking for the best spots to implement new trades in different markets tied to China’s near-term economic implosion; and managing positions to handle the inevitable volatility (hope driven rallies and sharp, swift declines) that will ensue. 4 NOTES 5