Pain is Coming to Chinese Stocks

Downgrades, Disappointing Data and Structural Challenges Will Likely Make Chinese Stocks Unpopular for the Remainder of 2024

"Simply put, in many crucial economic sectors, China is producing far more output than it, or foreign markets, can sustainably absorb. As a result, the Chinese economy runs the risk of getting caught in a doom loop of falling prices, insolvency, factory closures, and, ultimately, job losses. Shrinking profits have forced producers to further increase output and more heavily discount their wares in order to generate cash to service their debts." -By Zongyuan Zoe Liu, China's Real Economic Crisis

It is a bold claim to state you can provide research that can beat markets. Over time, most people are more than humbled by the markets, they are humiliated by them. At Punk Rock Traders, we provide higher risk, higher return trades than many on Wall Street are willing to provide. Part of having success is taking directional bets based on qualitative research insights. Part of what we do is also provide nimble advice to investors who know what to do with it. We take you up in the plane, but you have to bring your own parachute.

One of the best ways to reliably find alpha in markets is to challenge common notions that have become stale, false, or even comical in the face of mounting evidence. Given the intense emotionality and domestic political incentives associated with the perception of geopolitical risk, I find this area a prime one to harvest the false beliefs that we can turn into alpha. There are still a lot of misconceptions about China in the zeitgeist, but as far as the professional investment community goes, it appears the canaries in the coal mine are sending an ominous message:

• JP Morgan, the most bullish investment shop on China, recently downgraded its China-associated holdings to neutral. The firm joins other recent downgrades from UBS and Nomura.
• The Chinese economy has struggled to show anticipated post-COVID strength and recent numbers have cast doubt on state growth goals of 5%.
• A lot of fund managers are preferring to allocate to other areas in ASEAN markets that have less short-term obstacles to growth.
• Recent $PDD earnings showed an anemic Chinese consumer, raising fears of a continued sluggish recovery from COVID.
• As US election season closes in on November, the risk of a second trade war with China is particularly acute from their point of view. Given their rising overproduction issues, any trade war that isolates them from large foreign market partners will particularly sting.

Yesterday's notion of the Chinese economic miracle should be all but shattered to astute observers, Xi's consolidation of power has had direct casualties and costs. One of the major casualties has been the focus on economic liberalization.

The state has taken a more active role in both the economy and society, yet very clear limitations that might be described as shocking materialized when the Chinese street exercised popular sovereignty over the zero COVID issue. This Black Swan risk of a politically active Chinese populace could always reemerge quickly. I think it is underpriced.

China thus has building risks of a common authoritarian descent into economic malaise. The state is encouraging actions, like starting duplicative production efforts in the state's preferred industries all cobbled together with cheap financing that exposes the wider economy to massive risk.

The state's preferential treatment of industrial capacity over domestic consumption is starting to come to a breaking point for the Chinese economy. Authoritarian meddling in the economy is likely to come to a head with building demographic problems. The party's unjustified hubris doesn't help, either.

Despite the massive economic miracle achieved by the CCP, much of it was lobsided. So while China had great GDP numbers development in other areas of its economy sagged behind which have caused economic problems. The current health insurance crisis in the country illustrates part of the reason the Chinese consumer is weak. It is also an example of uneven development.

I see the building uncertainty around China likely to be unresolved until at least a serious growth/deflation scare occurs. The Chinese economy is just too straddled to industrial production and I think the chickens will come home to roost sooner than many expect on the overproduction problem now endemic in the Chinese economy.

The Chinese stock market also has different cultural significance than our stock market. The domestic real estate market is much more important for the Chinese wealth effect, and sluggishness here is also weighing on an increasingly demoralized Chinese consumer. And even if you put the cultural difference aside, the behavior of Chinese consumers is showing that they are preferring short-term deposits instead of other longer term investments. This is a decidedly bad sign for the Chinese economy and shows an increasing distrust of financial assets.

While a robust Chinese state has more leeway than we do to paper over financial crises, the problem is that they may have pulled that lever too many times. Confidence in the Chinese banking sector is diminishing as it increasingly shoulders debt burdened local governments and bad real estate debt.

I think there are two trades to take advantage of building weakness against the Chinese economy. I don't think this weakness is short-term, I think the entire system has been stressed by COVID, and that many previous economic realities that people were banking on are no longer intact. A manic focus on industrial production has crippled the Chinese economy and the Chinese E-Commerce giants are increasingly involved in commoditized competition that is crimping profits and growth.

I think a good target to short the Chinese economy is Alibaba ($BABA). The firm is growing revenue at only 4% a year which is much less than competitors. It's less than Wal Mart. The growth there appears concentrated International Digital Commerce group but the rest of the segments are acting like dogs, even cloud which is only growing at 6%. Again unimpressive compared to peers. This is a long term bet on the weakness of the Chinese economy. Thus, I am recommending a LEAPS to short $BABA.

• Buy the Sep. 19th 2025 $80 puts on $BABA. This gives time for the weakness in the Chinese economy to manifest itself and for the stock price to materially decline from current levels. These are currently trading at $8.75.
• There could be a pop if the Chinese government offers stimulus in the next month or two. If this happens, I would view it as an opportunity to double down on this position.
• For more risk averse investors who don't want to be exposed to a single stock, I would recommend shorting $KWEB with the January 16, 2026 put options at $25. These are currently trading at $3.00.

Finding alpha in geopolitical risks can be difficult. However, I think it is clear that the Chinese economy is suffering from a post-COVID hangover that is likely more indicative of a convergence of a weak consumer, government meddling in the economy, and demographic decline are going to make the high growth a thing of the past.

Another thing about the short-term picture for China is that the spate of downgrades and the better growth figures in other countries should naturally distract capital away from China. The loss of momentum is greater than just the recently weak factory numbers. The entire Chinese economic system is stressed from banking to Real Estate. I suspect the weakness will show itself in the Chinese stock market over the coming quarters. The problems are becoming big enough where fancy party footwork may no longer be able to provide an acceptable facade.