By Justice Litle
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.

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.

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."

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.

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