margin calls

When I looked at my Fidelity account this morning I saw two odd things:  a simplified interface, and a message sent to everyone with a margin account (my wife and my joint account with Fidelity is a margin account, although we don’t trade on margin).  The message was essentially a warning to be on the alert for potential margin calls.

I’ve never seen this before.  A caveat:  until I retired at the end of 2006 all the family money was in the mutual funds I was managing, in whatever vehicle my employer required.  Still, I didn’t see this in 2008-09.

Two conclusions:

–Fidelity is anticipating/seeing volume increases that are testing the limits of its software (probably mostly an issue of private-company-esque aversion to spending on software infrastructure)

–more interesting, aggregate equity in the accounts of its margin customers must be dangerously (for the customers) low.  Margin-driven selloffs are typically ugly–and very often mark a market bottom.  Here’s why:

margin trading

In its simplest form, a market participant establishes a margin portfolio by investing some of his own money and borrowing the rest from his broker.  He pays interest on the margin loan (Fidelity charges 5% – 9%+, depending on the amount) but all of the gains/losses from the stocks go to him.  The client does relinquish some control over the account to the broker.  In particular, the broker has the right to liquidate some/all of the portfolio, and use the proceeds to repay the loan, if the portfolio value minus the loan value falls below specified levels.

Before liquidating, the broker tells the client what is going to happen and gives him a short period of time to put enough new money (securities or cash) into the account to get the equity above the minimum amount.  This is a margin call.

If the client doesn’t meet the call, the broker begins to sell.  The broker has only one aim–not to get the best price for the client but to convert securities to cash as fast as possible.  Of course, potential buyers quickly figure out what’s going on and withdraw their bids.  Carnage ensues.

That’s what Fidelity was saying we’re on the cusp of this morning.

There are some very shrewd and successful margin traders.  Around the world, though, retail margin traders are regarded as the ultimate dumb money.  That’s why seeing forced selling from these portfolios is typically seen as a very positive sign for stocks.

 

 

 

Chinese stocks—and related ETFs

I got home late last night and flipped on the TV to watch baseball.  What came on first was Bloomberg TV, where reporters in London (?) and Hong Kong were exchanging near-hysterical comments about the declining Shanghai and Shenzhen stock markets.

The facts couldn’t have been much more at odds with their dire pronouncements.  Yes, the markets were down by 2% – 3%.  Yes, a small number of stocks were limit down.  But the markets were relatively stable and trading was orderly.  Given, however, that the main concern for global investors, as well as Chinese participants in the domestic stock markets, is to have China shrink the still-large amount of margin debt outstanding without a market collapse, overnight market action in Shanghai and Shenzhen  was a very positive development.  As it turns out, although the markets closed down slightly for the day, they were even up at one point.  Volumes were reasonable, too.  Let’s hope this continues.

(An aside:  the Bloomberg TV spectacle I witnessed is one more illustration, if anyone needed it, that the recent shakeup of the Bloomberg news organization is taking it further down the road toward infotainment and away from analysis.)

 

I came across a Factset article this morning discussing the performance of ETFs that specialize in small-cap Chinese stocks.  These have been the center of speculative activity in China over the past year.  But they have also been an area subject at times to protracted trading suspensions for some stocks and to days where some have been limit-up or limit-down with no trade.  The short story is that thanks to fair value pricing the ETFs themselves have experienced no problems.  More on this tomorrow.

Chinese stock markets

After recently stabilizing and then rising by about 15%, Chinese stock markets gave up half their gains overnight, causing worry in global financial markets.

For what it’s worth, given that I don’t follow the mainland Chinese stock markets carefully, this is what I think is going on.

Three important factors:

–a government crackdown on real estate speculation has shunted tons of “hot” money into stocks

–Beijing didn’t pay much attention to direct and indirect margin trading ( indirect meaning commercial loans collateralized by stocks bought with loan proceeds, which avoid the letter of the law), thereby allowing speculators to leverage themselves very highly

–stock market rules set limits on the daily movement in individual stocks to + / – 10%.  The way this works is that the exchange attempts to set an opening price at the start of the day.   Let’s say yesterday’s close was 100.  The exchange sees there are sellers at 100 but no buyers.  So it waits a little while and then moves the proposed opening to 99.50. Again sellers but no buyers.  So it moves the proposed opening to 99.  Same thing.  So the proposed opening price continues to ratchet down either until buyers emerge or the proposed price reaches 90.  In the latter case, the price remains at 90 until either buyers appear or the trading day closes.  The same process happens the following day.  (Of course, there might be overwhelming upward pressure as well, in which case the price ratchets up without trade, or stocks might trade–as appears was the case overnight–for part of the day before reaching the daily limit price.)

snowballing downward pressure

A big problem with the daily limit system is that in times of stress often no selling gets done.  For speculators who get margin calls, this means that each day the amount they owe their broker rises (as the market falls) and they can’t take any action to stop the bleeding.  So a horrible sense of panic comes into the market.

The resulting downward spiral is what Beijing was trying to fix when it initiated extraordinary market stabilization measures a short while ago.

The first step in recovery is to stop the market decline.

The second–which is where we are now, I think–is to begin to unwind the enormous margin position that Beijing inadvertently allowed to develop.  The only way to do this is to gradually withdraw the official props under the market, not enough to have the market freeze up again but enough to allow selling to happen.  My guess is that this is what is starting to go on now.  The keys to watch are volume figures and the total value of transactions–the higher, the better.  Unfortunately, I can’t volume figures for today’s trade anywhere.

effects?

In my experience, most emerging stock markets have problems like this in their early days.  Once the crisis is over, authorities usually pay better attention to margin debt.  Invariably, they effectively dismantle the daily limit rule.

Typically, stock market problems have no overall negative effects on the economy.

In the short term, however, margin or redemption selling can create perverse market signals.  Forced sellers liquidate what they can, not necessarily what they want to.  This means, for example, that Hong Kong stocks can come under pressure.  It also suggests that smaller, low-quality stocks may outperform blue chips–the former will be suspended while the latter go down.

This can be a real disaster for margin speculators, who may be left with an account that technically has equity in it but is filled with unsalable junk.  On the other hand, the forced nature of a margin-related selloff can give new entrants a chance to buy high-quality stocks at distressed prices.

One seemingly odd sign that the worst is over will be a collapse in smaller stocks as larger ones are beginning to rise again.  This means that buyer interest is returning to the smaller ones and they’ve resumed trading, which is a much better state than they’re in today.

Another, perhaps lagging, indicator that the worst is over would be Beijing ending the daily trading limit rule.

How long will the cleansing process take?

I don’t know enough detail to have an educated guess.  A couple of months would be my initial estimate.

 

 

 

the impact of daily price fluctuation limits on Chinese stock trading

As I’ve said in prior posts, I have no desire to buy shares on mainland China’s stock exchanges.  Hong Kong is fine enough for me.

This has led me to not pay enough attention to what may be a key feature of trading there–daily price fluctuation limits of +/ – 10% per day.  What this means in the current context is that a given stock can trade down until it has fallen by the maximum 10%.  Unless/until there are buyers at the -10% level or better, there is no more trade in the stock that day.

While this was common practice in stock markets around the world several decades ago, and is the norm in commodities trading, it is no longer the case in most stock markets.

The reason is that it prevents markets from clearing quickly in times of stress.  It tends instead to increase investor fears and to deepen stock market losses, as well as lengthen the selloff period.  I first saw this very clearly in the cases of Mexico, Spain and Thailand during the market downturn of October 1987.  All three countries had daily fluctuation limits.  After a number of days of limit-down-no-trade, Mexican authorities loosened the bands and the market began to clear.  Spain and Thailand didn’t.  Both markets suffered severe selloffs that lasted for months.

 

Press reports on China have alluded to the daily price fluctuation rule there.  But the authors haven’t a clue as to its significance; they provide no useful information about how it is impacting trading.  They do indicate that many small caps aren’t trading, but that would likely be the case whether price limits were in effect or not.  (Typically, one of the early signs of market recovery is that small caps go down.  The positive signal is that buyers–at any price–have reemerged.)

The 10% rule may be having negative effects on Chinese stock markets. The way to tell would be to examine the most liquid stocks and see if they are closing on the lows, with the last trades significantly before the market close.  Given the behavior of the overall indices and the overall trading volumes, I don’t think this is the case to a crucial degree.  But at this point I’m not curious enough to check.

Even so, it seems to me that Beijing could shorten the period of margin-selling downward pressure on the market if it were to modify or eliminate its old-fashioned daily limit rules.

(a little) more on the Chinese margin crisis

Chinese stocks closed lower by about 5% overnight, as the margin selling spiral continues downward.

My thoughts:

–this very strongly suggests that some margin accounts that have enough equity in them a day ago are under water now.  So Shanghai and Shenzhen will likely open tonight to more selling.

–to be clear, I don’t know exactly how Chinese margin works.  And, because I have no intention of buying A shares, I have no desire to find out.  A logical step for authorities to stop forced selling would be to loosen margin collateral requirements.  It may be, however, that the government has decided that the best course is to wring speculation out of the market as quickly as possible.  In other words, despite its rhetoric, it’s content to see the selling play itself out fully.

–margin players tend to be their own worst enemies.  Taking both their margin and cash accounts into consideration, they tend to have a mishmash of high quality stocks and speculative junk.  Their margin accounts tend to be heavily weighted toward trash.  The junk is what’s most vulnerable to price declines, since it has little, if any, intrinsic merit.  The logical response to a margin call is to sell the trash and keep the quality names.  Margin players, in my experience, invariably do the opposite.  They sell their winners and keep their losers, exposing themselves to continuing margin calls and prolonging the overall market agony beyond what it should be.

–I’m still guessing that the current selling will exhaust itself within two weeks.