China’s short lesson is sending a powerful message

Stock shorters were caught short in resources shares when China cut its rates, and there could be more good news to come.

It’s always great to see the shorters get routed. And that’s exactly what happened when the Chinese central bank caught everyone by surprise by lowering interest rates.

The hedge funds were shorting resource shares, punting on depressed global growth, led by a slowing China. But if China is cutting rates to stimulate consumption and economic expansion, being short the resource producers becomes very dangerous.

Accordingly, over the weekend the shorters absolutely panicked and began covering (buying back) their resource stock exposures, causing the world’s number three iron ore company Vale to jump 8 per cent, while Teck of Canada rose 9.4 per cent and Anglo moved up 5 per cent. 

And the short covering extended to Monday’s Australian market, with Fortescue up a massive 10.8 per cent (9 per cent of the stock had been shorted), Arrium up 10.4 per cent, OZ Minerals 8.6 per cent and Iluka 6.3 per cent. BHP and Rio Tinto, having risen 4 per cent over the weekend, settled for rises of 3.8 per cent and 3.3 per cent, respectively. Predictably, Rio and BHP shares slipped back in London overnight once the shorters were covered, and the miners' shares in the local market followed suit.

In Australia, the big institutions who hold the savings of those Australians who do not have a self-managed super funds, love to lend the certificates so that the shorters can depress the stocks into which Australian savings are invested. Who cares if the client cops it in the neck?

The fact that the big institutions have been losing market share to self-managed funds is in part due to this cavalier attitude to the people who trust them with their money.

But when hedge funds sell a stock in which they do not have beneficial ownership, their potential loss is unlimited. Once an unexpected event triggers buying and the stock rises, people clamber to cover.

And that’s what happened when China raised interest rates. There is no way a small reduction in China’s interest rates warrants such a massive reappraisal of resource stocks. The glut in coal and iron ore is not going away, so the short covering may be creating only a short-term rally.

One of the most vocal critics of short selling is Richard Morrow of Baillieu Holst, and I am grateful that he alerted me to what was happening.

Now, of course, there are many other Australian stocks in which the institutions have loaned the stock of our savers to shorters, causing that stock to fall in price.

Among the big shorting positions, where more than 10 per cent of the capital has been shorted, are Myer, Metcash, Acrux, JB Hi-Fi, Atlas Iron, UGL, Paladin Energy, Regis Resources, Kingsgate, Mineral Resources, Cochlear and Nexdc.

To see Myer and JB Hi-Fi with so much stock shorted is an indication that the shorters think it is going to be a bad Christmas.

Imagine the panic if the Reserve Bank followed China and lowered rates in December. That’s not a forecast, but too big blows to shorters in a few weeks would be an absolute joy.