As Grant’s Interest Rate Observer has been known to say, “We wrote it. Did you read it?”

My slim hope is that the Chinese really and truly know what they are doing, because, in fueling investor optimism with such flair, they are playing a high stakes game. My worry is that they drop the ball, somehow, and the result shows up as a violent wake-up call for “high beta” assets… emerging market equities, energy, commodities and the like.

What happens next is far from clear. The huge [commodity] stockpiles could continue to grow at a breathtaking pace – after all, Beijing has plenty of greenbacks to work through – and the dragon’s data points could continue to impress, or at least not frighten.

But with that said, a stumble from the dragon… and the shock of a sharp, swift deflationary contraction immediately following… does not feel like a far-fetched scenario at this point. It would certainly have profit potential as a surprise event, given how far the notion seems to be from Mr. Market’s mind.

– Taipan Daily, June 12, 2009, “The Fate of This Rally May Rest in China’s Hands”

On Monday, the violent wake-up call arrived. You could say the week started off with a bloodbath… a “decoupling” bloodbath that took many investors by complete surprise. (But none who are readers of Taipan Daily we hope.)

The brutal sell-off was more or less led by emerging markets and hard assets. It was as if the World Bank had rung a bell. Out of the blue the race was on to sell anything and everything with any sort of connection to the grand “decoupling” theme.

Speaking of the World Bank, they are the ones to whom the financial media assigned blame. It was an awfully gloomy World Bank forecast, the wires suggested, that led to the carnage on an otherwise light news day.

But as Bespoke Investment Group astutely asked, since when have traders ever paid attention to the World Bank?

The need to match up trading action with a particular news item of the moment shows an amusing failing of the financial press. Many journalists approach the market like a television sitcom… as if every day were its very own episode, with no continuity or chronological buildup of events.

China Weighs Heavy

In reality, the market had been inching ever closer towards a sell-off for some time. Volume was steadily shrinking rather than rising – a sign that the bull move was running out of steam. Public companies were coming out of the woodwork to issue record amounts of stock. Unconventional measures of sentiment, like the bull-bear ratio of money flowing into Rydex funds, showed worrisome levels of optimism. Ill winds were blowing on multiple fronts, as we noted in these pages.

And, perhaps most importantly, the magic pixie dust sprinkled by China had finally begun to wear off.

The bulls happily embraced the China story and ran with it as fast and far as they could, taking oil and copper and the like to eight-month highs.

But, as it turns out, much of China’s stockpiling drive looks to have been pure speculation. And not even official speculation sanctioned and planned out by the mandarins in Beijing… but instead a fast and loose misallocation of funds.

As part of China’s economic stimulus plan, Chinese banks were ordered to lend massive sums to steelmakers, iron ore importers and other industrial players. A large portion of these funds was plowed directly into big commodity price bets.

The iron ore debacle, for example, was almost certainly a result of speculative excess at the local level. Many traders scratched their heads on hearing the news of 90 large iron ore freighters idling in the water for two weeks or more, waiting to unload at overflowing Chinese ports.

Who would plan such a thing? Nobody would. The backlog came about due to a communication snafu. Stockpiling decisions were made by cash-flush managers at the ground level, as a wave of stimulus funds encouraged them to gamble. Beijing lost control of how those funds (handed out as cheap loans) were being used.

This kind of thing is bad news on multiple fronts.

For one, it highlights how little control Beijing actually has over how China’s stimulus funds are being spent. For another thing, it puts many ground-level Chinese industrial producers at risk of insolvency if the price of, say, iron ore falls too far.

“Last year people who stockpiled went out of business,” notes Shanghai-based economist Andy Xie. “I know one distributor who stockpiled six million tonnes of steel and went bust when it dropped by more than half.”

Making Sense of the Story

There are at least two important lessons here. The first one is, try to make sense of the story. In my trading service, for example, I have been wary of the “China leads the world” theme for months, mainly because the basic story line (as touted by the bulls) never quite made sense.

Meaning, how was China ever set to lead the world into recovery when China itself is still so dependent on exports to a weak global economy? How can Chinese business activity truly be picking up with electricity usage falling, rather than rising?

And how could a stimulus plan slapped together by Beijing bureaucrats really solve the issue of internal domestic demand – China’s biggest hurdle and a challenge that simply will not succumb to short-term fixes?

There is a big bullish story in China. But as with other emerging markets, it is a longer-term story, hinging on the day when these countries truly make strides towards weaning themselves from the economic crutch of exports to the West. We are closing in on that point, but are not quite there yet.

Trader or Investor?

Another important lesson is recognizing the difference between trading and investing, and not getting caught in the no man’s land between the two.

A good working concept here is “the Mountain and the Valley.” Here’s what I mean:

Imagine a great, vast mountain off in the distance. You don’t know exactly how far away it is, but you know it’s there, waiting to be scaled. Meanwhile, in between you and the mountain is a fog-covered valley. You don’t know what kind of ups and downs will be in that valley, but you know the trip across won’t exactly be smooth.

The difference between trading and investing is, investors tend to focus on the mountain and more or less ignore the valley. They keep their financial and emotional risk low enough to handle the ups and downs without losing their cool. Deliberate staying power and long-term conviction are the operative phrases here. With those two things, many hard asset and emerging market investors will be able to look past the volatility of recent days and ultimately do just fine.

In contrast, the trader is very aware of the ups and downs of the valley. Rather than ignoring that volatility, the trader focuses on it. The trader’s advantage is thus speed and flexibility – an ability to buy and sell a position repeatedly as need be, get a sense of how the terrain is going, and move quickly and fluidly when the timing calls for it.

So which one are you? Steadfast and true, or flexible and fluid? The two temperaments are rather different. Some versatile folks are traders and investors at the same time, but even then, not often with the same positions (or even the same brokerage accounts).

In closing, do emerging market equities and hard assets still offer excellent long-term investing opportunity? Absolutely, without question.

In the eyes of the investor, this week is just another dip in the valley. But in the eyes of the trader, China’s stumble – and the demise of the bear market rally – have created a shift in the near-term landscape worth exploiting.

Source: Commodity Bulls Snared by China Stimulus Snafu