A reversal in extreme negative market sentiment requires a defining moment that can cause investors to act irrationally or just give up.

Well, capitulation may have finally arrived. Whether you believe if the CCME saga was an example of “innocent before proven guilty” or “guilty before proven innocent”, the end result will be the same – there will be a mass exodus out of the ChinaHybrid RTO space, which has already begun. Company auditors and the status of internal controls will begin to hold less weight in investors’ minds. Companies may just slowly disappear or walk away, especially the ones that need capital and now find the process more difficult. Investors need to send a clear message to IR firms and Ibanks by not blindly giving capital (see article ) to firms where filings and stories are not in order. Going a step further, the SEC should not permit Ibanks and IR firms to peddle to these companies, unless a clearly defined and acceptable due diligence process has been completed.

If your portfolio exposure to the ChinaHybrid space is less than 20%, something we have been preaching as a consideration for some time now, then it should suffer minimal collateral damage as events play out. If you are short names that, combined with on-the-ground due diligence, embody the characteristics of  foul play such as mismatching SAIC/SAT/SEC filings, stupid capital raises, acquisition transactions that do not make sense and misrepresentations of land use rights, then you will make money from this phase.  Creating a small portfolio of short positions in suspect or even illiquid stocks, even at these prices, should work overtime as many will slowly fade away as China Education Alliance (NYSE:CEU) has been doing.  We have had some success shorting stocks that have risen on good news , such as earnings, expecting prices to retrace to the downside.    Be very careful when purchasing shares of companies that have not released their 10K’s yet.  Shengda (NASDAQ:SDTH) and China Agritech (NASDAQ:CAGC) are two of the latest victims who have had shares halted due to audit issues.   Subaye (NASDAQ:SBAY), a company we suggested that investors tread carefully with and and in fact shorted, is also experiencing delays in filing its 2011 fiscal first quarter report as its new auditor, PWC,  peels away the onion. To see what we have discovered please see the following note.   We are also still waiting for the Tri-Tech (NASDAQ:TRIT), a company that entered the U.S via an IPO, to release its 10K, even though they have released 2010 year end results.

There is, however, a silver lining.

With every capitulating event, a new bull can emerge in its place. New regulation, more auditor scrutiny and intense on-the-ground due diligence will raise the bar for ChinaHybrids that desire to gain respect in U.S. capital markets. What hopefully will emerge from this much needed cleansing process is a healthier and more reliable market scenario, although it still remains uncertain how many names will rise from the carnage. The irony is that the same group who exposed the space for what it is will be the same faction that will help fuel the possible ensuing bull. Let there be no doubt, they will begin buying the legit companies and ride them to P/E multiples we have not seen yet. Once again, they will use the power of on-the-ground DD and SAIC filing analysis to build their cases. Until we can take solace that auditors have a good grip on the vague practices of  ChinaHybrids, investors should not risk long-term capital in these companies unless they have access to necessary  outlets of information.

We also will continue to take a closer look at companies that listed in the U.S. through IPOs, although finding value in these stocks is challenging as many of them have high valuation ratios.  A few Chinese IPOs that we have begun to actively track and will pull SAIC filings on include China Real Estate Info Co Adr (NASDAQ:CRIC), Sinotech Energy (NASDAQ:CTE), Rda Microelectronics (NASDAQ:RDA), Netease.com Adr (NASDAQ:NTES), Giant Interactive Group Ads (NYSE:GA) and  Airmedia Group Adr (NASDAQ:AMCN).

We look forward to using the following weeks to possibly build a wish list of companies that go unfairly punished in the possible wave of ensuing panic.  We can not predict how many stocks will recover from the recent culmination of events, but we are beginning to find companies that are passing our due diligence screens.   Of course, we will still weigh auditor rankings high on the due diligence scale, especially for companies who will be scrutinized as they attempt to upgrade. At the forefront of our efforts, SAIC/SAT filing analysis and on-the-ground DD will dominate our bullish or bearish motivations. It is funny how we have come full circle to where SAIC filings will take precedence over SEC filings.  If you are still a doubter, see a very relevant and related article intended to supplement the views here.

Disclosure: Short SBAY, No Positions in all other stocks mentioned at time of article