thinking about China: deflating a stock market bubble

For most of the 30 years I’ve been watching China-related securities, the mainland stock markets have been an afterthought for virtually all foreign investors.  The same for the authorities in Beijing, as far as I can see.  They seem to have regarded the equity markets as a vehicle for funding moribund state-owned enterprises that no bureaucrat in his right mind would give money to.

The mainland markets have gradually morphed over the past decade into something more interesting, as smaller, more innovative firms elbowed their way in.  But the market remains very hard for foreigners to gain access to, and is arguably still not worth the trouble.  The real action remains in Hong Kong.

 

Last year, faced with a bubble in the domestic property market created by a flood of investment money with no place else to go, Beijing decided to redirect this flow of funds to the Shanghai and Shenzhen stock markets.

In solving one problem, however, Beijing created another.

The issue was partly that the mainland exchanges were going through the roof in US-internet-bubble fashion.  In addition, however, the rise was fueled in large part by borrowed money.  Worse, this consisted not only of official margin lending but also by huge amounts of sub rosa margin disguised as either uncollateralized borrowing or debt secured by businesses or property.  No one knew how large this total debt was–only that it was gigantic, and that inexperienced retail equity investors had leveraged themselves to the sky because they had taken government encouragement as a guarantee against losses.

 

As/when the market peaks and begins to decline, margin loans come due.  When speculators can’t add more money to margin accounts (as is inevitably the case), this triggers forced margin selling that feeds on itself and turns into an avalanche of downward pressure.  Once selling starts, it can be almost impossible to stop.  Of course, as soon as potential buyers realize what’s going on, they withdraw and wait for the market to hit bottom.

This precarious development in Shanghai/Shenzhen is not a unique phenomenon.  The same thing happened in 1985 in Singapore/Malaysia, in 1987 in Hong Kong, and in 1997-98 in many smaller Asian markets.  In hindsight, Beijing could possibly have averted the crisis by raising margin requirements and by cracking down on unofficial margin loans by financial institutions.  But it didn’t.

Beijing seems to me, however, to have followed the standard protocol for dealing with a mammoth overhang of margin selling and restoring order to the market, namely:

  1.  identifying and cutting off borrowing sources

2.  prohibiting short sellers from exacerbating the problem by speculative selling

3.  buying enough stock, either directly or indirectly, to reduce forced selling to a level that the market can handle unaided

4.  allowing the market, once functioning again, to clear by itself.

The way I look at it, we’re in #4 now.

One other comment:

in the US, the rise and fall of the stock market is regarded as the most powerful leading indicator of future economic performance.  I don’t think that what’s going on in Shanghai/Shenzhen stock trading has much macroeconomic significance.  Rather, the China stock market fall is an obstacle that every emerging market encounters on the way to stock market maturity.

 

 

 

 

 

 

 

 

 

 

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.

 

 

 

Shaping a portfolio for 2015: elaboratng on yesterday’s post

A reader had two questions about yesterday’s post, which I figured it would be easier to answer here than simply in a comment.

emerging markets

The big attractions of emerging economies to an equity investor are the possibility of very rapid economic growth for the country and of finding future titans of world industry as infants.  The two standard paths of gaining exposure to these markets are: to invest directly or to buy a developed-world multinational with significant presence in the economy in question.

Some emerging markets aren’t open to foreigners.  For those that are, the most important thing to realize, I think, is that there is typically little local support for stocks.  There are usually no pension funds or other local institutional investors (because there are no pensions and residents aren’t wealthy enough to afford financial products like insurance).  Local citizens don’t have enough money to be able to own stocks.  As a result, emerging market performance ends up being heavily dependent on foreign inflows and outflows.

Foreign flows can be very cyclical.  When developed market investors are feeling confident, inflows to emerging markets are typically very large.  When they’re scared, outflows are the order of the day.  Because there’s little local buying power, these outflows invariably cause sharp price declines.

Right now, oil-exporting emerging markets are being hurt very badly by the declining price of crude.  investors are also worried that emerging markets-based companies may have borrowed excessively, in US$, during the past few years of easy credit.  Such debts were a big factor in the crisis in emerging Asian markets that started in 1997.  In fact, today’s developments in Russia sound a lot like what happened in Malaysia in the late 1990s.

Yes, emerging market will eventually settle out.  I don’t think we’re anywhere close to that point, though.

rent vs. buy

Take Adobe.   Say you’re a web designer who wants to start a business on your own and that you want to use Adobe tools.

Buying a Creative Suite package to get started used to cost $2,500 – $3,000.  That’s a lot.

Many people would do one of two things:

–bite the bullet and buy, but never, ever upgrade; or

–find a bootleg copy on Craigslist for $200 or so.  Yes, it would probably stop working after six months, but it was cheaper than getting an “official” copy.

How many people took the second route?   I don’t know  …but probably a lot. I once heard Bill Gates estimate that 40% of the small business users of Office in the US were using counterfeit copies

Adobe has now gone over to a rental model.  $50 a month gets you access to the Creative Cloud version of all the Adobe tools.  The same sort of thing for photographers–$10 a month for Photoshop + Lightroom, vs. $600 to buy  (Amazon is selling the last disk version of Photoshop for $1500).

The plusses:

–the move from buy to rent changes a big one-time capital expenditure by a small business customer into an affordable monthly operating expense.  If users stay subscribers for at least five years, Adobe gets more money from rental than from a sale.

–Just as important, matching the tool expense more closely with customer cash flows is bringing a whole bunch of former illegals into the fold

–the company may also be attracting casual photography users who would never before have contemplated using Photoshop, but for whom $10 a month isn’t a big deal

–subscriber growth has continually exceeded consensus expectations.

The rental model isn’t exactly new.  It has been used for all sorts of equipment for years, from copiers to burglar alarms to colonoscopes.

What surprises me is that Wall Street has been so slow to figure out that the rental model works for software, too.  Yes, in the early days, the accounting looks ugly.  In fact, the faster the transition to rental goes, the uglier the income statement looks.  Development expenses remain the same, but instead of chunky sales revenue, the company only shows subscription payments for that month.  But professional analysts should be able to see past that.  My guess is that they miss completely the bootleg copy phenomenon.

 

 

 

 

 

problems in emerging countries (ii): financial markets

First, a small–but important–distinction.  There are emerging markets located in wealthy nations.  They focus almost exclusively on trading of local securities in countries where not many companies are listed and where locals have little interest.  Germany used to be one such backwater–and still is, to some extent.  Eastern European countries, members of the EU but with rudimentary securities markets, are another.

Then there are emerging countries, and their stock markets.  This latter group is what I’m writing about today.

emerging countries’ markets

The securities markets in emerging countries have two important characteristics that I think most investors are unaware of:

1.  There’s very little local demand for stocks or bonds.  There are usually no institutional investors, because there are no pension funds.  The average citizen works a 60-hour week to make, say, US$125.  He has no money to put at risk by buying bonds or stocks.  He may not trust his local financial institutions.  Instead, he may buy gold and bury it in the back yard.

This means that the local markets rise and fall on demand from foreigners.  When times are good, foreigners pile in and financial instruments soar.  The longer the boom, the deeper into unknown waters (smaller markets, micro-cap stocks) they wade.

Eventually, the tide turns.  The first to leave quickly exhaust local demand.  The rest can find no one to sell to.  Around 1990, for example, developed country investors “discovered” Indonesia toward the end of a long bull run in emerging markets.  After the party wound down, it was at least two years before investors with large holdings in Indonesian stocks could even begin to pare them.

2.  Local rules can change quickly.  Changes can apply either to everyone or just to foreign investors.  Capital controls can be imposed that would allow foreigners to sell securities but prevent them from exchanging the local currency they get for anything else, or would forbid them from removing sale proceeds from the country.

Or the government might simply tell foreigners they couldn’t sell   …or could unofficially tell local brokers they could not accept a sell order from a foreigner or process a completed transaction.

Not good.

active managers vs. index funds/ETFs

Veteran investors in emerging markets generally understand that the battle of wits between buyer and seller can sometimes turn into a game of Whack-a-Mole, with them in the role of the mole.  They cope either by staying completely away from the riskiest markets or holding only the safest names in small amounts.  They meet redemptions by selling some of their holdings in larger, more stable markets if they’re caught in a no-liquidity market.

This is a plus and a minus.  On the one hand, fund investors can get their money back.  On the other, by rerouting selling from risky to more stable markets, meeting redemptions ends up creating a minor kind of contagion.

Index entities, on the other hand, have little discretion.  They don’t have active managers to do selective selling.  They don’t want active managers, either.  What if the manager sells the wrong stuff and the fund/ETF underperforms, as a result?

ETF selling, which I’ve read has been quite heavy recently, exerts downward pressure on everything in the index–good or bad, sound country or not.  This ends up being another, stronger kind of contagion.

The question I don’t know the answer to is what an emerging markets index fund/ETF does with illiquid securities that its mandate (to mirror a specific index) forces it to sell but for which it can find no buyers.  My guess is that the firm that runs the index entity purchases the securities in question, after having a third party determine fair value.  I don’t know, though.

Anyway, problems in a few emerging markets can quickly spread to the whole asset class.

what to do

At some point, I think the right thing to do will be to look for an experienced emerging markets manager with a good track record, who works in a strong no-load organization.   Let him/her sort through the rubble for us.  I don’t yet feel a strong urge to do so, however.