Is A Market Crash Coming In 2015?
This article was originally published on Quora.
We are getting to the point that not even mighty James Altucher with all the chocolate in the world can save this market.
1) Liquidity drives markets swings, not valuation
The stock market is more subject to liquidity flows than either company or country fundamentals. This is reflected in the famous quote from Keynes that "Markets can stay irrational longer than you can stay liquid" .
As money is pumped into the system (i.e. Fed and other central banks holding rates near 0% and printing more more money) certain assets that were not considered cash equivalents have their "money-ness" boosted. That means that they can be used as collateral to buy other things (more leverage), further adding liquidity to the system. When the Fed and ECB accepted MBS paper as collateral that caused MBS paper to be cash. Asset monetization, when iliquid assets as real estate are used as collateral to back financial instruments, adds liquidity to the system. This works very well on the way up, but not on the way down.
2) Money Flows into EM (and other assets)
An expansion in liquidity in a major country's economy drives up its domestic stock market, real estate, jewelry, collectibles, art, private firms, startups, etc.
When the US (world's largest economy) boosts liquidity some of the money goes into EM. The map below helps to illustrate the problem when part of US money is directed into tiny markets (I will address China next ).
World Map by free float market capitalization (in $ billions)
Currently, the value of all shares listed in Brazil (this is the 8th largest economy in the world!) adds up to $684 billion. That is about the market cap of Apple. Any small change in investment sentiment by Fidelity, Vanguard, PIMCO, etc. which leads to a decision to over weight vs under weight a certain market causes huge swings (volatility) in the local market.
3) EM markets investors are overwhelmingly short duration
Unlike US or European markets, there is a lack of long term value investors in EM. These are pension funds, insurance companies and wealthy people (a.k.a. Warren Buffet types). That means that in the US, markets will bottom much faster (lower volatility) than in EM where most of the volume is made of hedge funds, prop desks and market makers (momentum investors).
To put this into layman's terms think about EM as the new hot restaurant in town. It is small, trendy, great menu, good value, etc. and people line up in front to try. The word gets out and the lines get longer and the bar more crowded because people are willing to undergo great inconvenience and long wait times for the promises of great food and average service. You don't mind being packed like sardines at the bar and giving $100 to the hostess to get ahead in line for your table. The restaurant is running above capacity for months but since everyone is "willing" to overlook the inconvenience all is OK. One Saturday night someone yells FIRE and people stampede to the door. Some people make it out with some bruises, some get run over and die in the fire. This is Emerging Markets Trading. In the US, the restaurant fire would eventually trigger sprinklers, paramedics would be at the scene quickly (value investors), and the number of casualties would be smaller (lower volatility).
The problem as some have spotted in the picture above is that China seems deeply under estimated. That is because the graph excludes A-shares and others that cannot be owned by foreigners. Adjusting for that, Hong Kong, Shanghai and Shenzhen are about one-third the size of US markets. That means that China is about 10% of global stock markets and this is not as trivial as Brazil or Russia.
The policies behind the Chinese growth machine have caused massive distortions in interest rates, currency, wages and asset prices, mainly real estate. And this has been going on for some years. Plus, members of the government have captures the lion share of the spoils as the Financial Times reported that the Chinese parliament has 83 billionaires. Most of the money from these billionaire government officials and also wealthy Chinese businessmen who benefited from those policies is not sitting in China. The same is true for other BRICS kleptocrats. This money is parked in Switzerland, fine art, cars/boats/planes, NY/London/Paris/Miami real estate, collectibles, etc.
The Chinese (and other EM) sovereign balance sheet is upside down with a big pile of debt and very little room to maneuver. As the government gets more desperate to reverse years of bad policies, it is naive to think the unwind will be mild. In July, after a meeting of between Chinese regulators and the heads to the top 21 brokerage houses we saw the following:
“The firms announced in a joint statement that to stabilize the stock market they would spend at least 120 billion yuan combined to buy exchange-traded funds linked to blue-chip stocks listed on the Shenzhen and Shanghai. Moreover, the firms pledged to hold all stock that had been bought with their own money until the index reached at least 4,500 points.”
As one analysts pointed out: if you are long the underlying asset and short a call option, you are effectively short a synthetic put option struck at the same price as the call option. This means that anyone who buys Chinese shares is short a complex synthetic put option on the market. If this is not bizarre I don't know what is.
China is extremely corrupt (same in other EMs where governments are still trying to make Socialism 2.0 work) and with an aging population. So a lot of so-called investment is wasted. That is because the increase in future consumption caused by the higher theoretical productivity the investment would generate will NEVER materialize simply because some projects are questionable and lots of money ends up in the hands of few.
5) House of cards
As Stephen Roach wisely pointed out: "You either believe in Globalization or Decoupling". You see people in CNBC and other so-called experts arguing for both. James Altucher is right that the media doesn't know anything. I prefer to believe they are stupid rather than liars. The world in increasingly globalized and there is no decoupling. Investors may overlook bad government decisions, but only for so long. Decoupling is a temporary illusion.
Let me bring it all together with a real world example and show how China and other EM can affect the US market. It has nothing to do with international trade and exports, but with built in self reinforcing loops in the system.
Chinese, Russians, Brazilians, Indians (and other EM wealthy citizens) who have been buying New York and Miami real estate as if they are hot cakes, now see the value of their in-country portfolio (liquid) diminish and the value of their US real estate (iliquid) rise. They have lots of money offshore (out of their home countries) sitting a JPMorgan, Credit Suisse, UBS, Goldman Sachs, etc. Those accounts usually have an overweight US focus. That means that the Chinese billionaire didn't take his money out of China to buy Chinese and Indian stocks, they buy Apple, ExxonMobil, Disney, Google, etc. A lot of the wealth created in EM markets over the last decade by so-called socialists made its way out and it is concentrated in the hands of few. Large part of this money is controlled by people who enriched quickly, are not really sophisticated investors and rushed to purchase assets in the US and EU to get money out of BRICS countries. Park that for a moment.
If you speak to real estate agents in NY or Miami they will tell that their international buyer has paid cash for their $10m condo and there is no reason to worry. They say their Russian/Chinese/Brazilian clients are not like the Americans who need a mortgage, they show up with $10m cash. Park that also in your mind for a moment.
When you speak to a private banker who oversees the money for these wealthy Chinese/Russian/etc. they will tell you that his/her client got a loan against his/her portfolio to pay for his condo cash. That condo is really not paid for. The client gave JPMorgan some $12m in stocks and got $10m in cash, which was wired to buy property (or a Picasso painting). That can create a huge problem for their personal balance sheet when the moeny stops flowing (plus developers and real estate agents in NY and Miami).
Putting all parked pieces into into motion. As EM slows down, the EM wealthy guy makes less and less money from his business, he may even have to put more cash to keep the business afloat (I personally know people doing this already).
1) The flow of money from his home country to his JPMorgan account that used to be $1m per month with the slow down and currency depreciation evaporates.
2) He needs that money to pay the loan to JPMorgan that he used the proceeds to buy the $10m condo.
3) He can't service that debt with money coming from his home country because of #1 so he needs to sell some stock.
4) If he has $15m in the account he can sell a maximum of $3m because JPM requires 120% coverage on the loan.He could wire $30m from UBS, but that is tied to another loan he got to buy a Picasso painting. Given the $1m he was sending from his home country is no longer available he has 3 months of burn before JPM liquidates his portfolio to repay the loan.
5) He call his broker and ask to put the condo for sell
6) The Fed raises rate so JPM adjusts the cost of debt on the loan collaterized by the stocks and now the client only has 40 days burn
7) Real estate broker says market is soft and it will likely take 6 months to sell. Suggests that he spends money on advertising and staging the condo. He call his art dealer and puts the Picasso for sale. In parallel his trying to get any of his Chinese friends to buy his multiple cases of Chateau Lafite.
8) US market down another 5% and JPM makes a margin call. Client cannot wire more money and JPM takes over the portfolio and sell in the market quickly to recoup the $10m.
9) This happens thousands of times as private bank clients cannot meet their obligations and the banks dump stock in the market, S&P500 goes down creating a self fulfilling prophecy.
This is just an example, BUT THERE ARE MORE PEOPLE IN THAT SITUATION THAN YOU THINK. Rich people (in this case the new rich from BRICS countries) also make stupid financial decisions, mismanage their liquidity and go broke. There are many more instances, but as long as you have liquidity problems markets will overshoot beyond the rational point. The only comfort is that a more developed market as the US will over shoot much less than any EM. China is most worrisome because it is much large than the others.
So James Altucher I suggest you book your trip to Shanghai with a stop in Switzerland because the Chinese like the good stuff and Hershey's is not going to cut it.
The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.
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