Published August 12th, 2015
The Chinese stock market as measured by the Xinhua China 25 Index (FXI) has declined 18.3% in the last 3 months.
The Chinese government is doing everything it can to prop up the country’s faltering economy and stock market.
The Chinese government recently drastically increased brokerage financing capabilities. Nothing screams ‘bubble’ more than investors buying on credit.
Heavily leveraged stock market speculation in the 1920’s is in large part what caused the Great Depression. Heavily leveraged real estate speculation in the early and mid 2000’s was the primary driver of the Great Recession of 2007 to 2009. If history teaches us anything, it’s that buying overpriced assets with leverage results in bubbles. The thing about bubbles – they always pop at some point.
Bubbles always come with ‘irrational exuberance’ – the idea that asset prices will go up indefinitely. Investors in the 1920’s assumed stock prices would continue rising as more people purchased. Real estate investors felt the same way in the early 2000’s.
Perhaps the best example of irrational exuberance is the late 1990’s early 2000 tech bubble. Investors were buying businesses that had no earnings for astronomical price-to-sales ratios. The idea that businesses even needed to make money anymore was being questions. Businesses exist to make money. If a business isn’t making money now, don’t invest in it (as a general rule).
The Chinese stock market has all the signs of a bubble. It is being propped up by cheap credit. Investors have long been overly exuberant on China – blindly assuming the country can grow at 10%+ a year indefinitely.
The problem with China’s economy is that a large portion of it is controlled by the public sector. Total government expenditures account for 24.8% of domestic output. Interestingly, the United States actually has a higher percentage of government expenditures to GDP at ‘well over one-third (33%)’ according to heritage.org.
What’s the problem with large government spending? It is not tethered to consumer demands. As an example – if a construction company were to build an entire city that no one lived in… It couldn’t. The company would go bankrupt after one or two skyscrapers (if it were a giant corporation). Investors would be outraged at the terrible capital allocation policies of management, and lenders would likely not finance the project.
Contrast this with China’s ghost cities. The best example is the city of Ordos. Ordos was built for over one million people – but only 2% of its buildings were ever filled. That’s not a great occupancy rate.
Government projects do have appeal in the short run. They provide jobs and boost the economy. Unfortunately, that is all they do. In the long-run, these projects are wastes of resources. If these ventures had favorable risk/return profiles, private investors would capitalize on opportunities. The more resources an economy wastes, the slower its growth will be.
More Attempts to Prop Up China
The Chinese government is doing everything in its power to prevent a recession. The country is giving cheap credit to investors to buy stocks. It is even using central bank funds to purchase stocks directly. The Chinese government has long financed large public works projects (like Ordos) – which are great in the short-run at providing jobs.
Now, the country is devaluing its currency in an attempt to become more competitive in international markets. The Yuan declined 1.9% against the U.S. Dollar yesterday, and is targeted to fall another 1.6% today.
A weaker Yuan will make Chinese exports more appealing on international markets. It also hurts current savers – who have seen their net worth decline 3.5% in the last two days in real value terms. Currency devaluations help exporters but hurt savers. The Yuan devaluation is yet another attempt by the Chinese government to put short-term ‘growth now’ goals ahead of long-term, sound free-market policies that would best allocate scarce resources efficiently.
The Big Picture
China has long been referred to as the ‘global growth engine’. What happens when the engine stalls? Markets are fragile around the world. Japan has a debt to GDP ratio of over 200%… Higher than even Greece. Speaking of Greece, the company has ‘kicked the can’ of government default down the road a few years (months?) thanks to yet another bailout and new austerity programs.
Still, much of Europe is heavily indebted and is struggling. The United States is also heavily indebted and seeing sluggish growth since the Great Recession.
The scariest part about slow growth in the developed world over the last several years is that governments and central banks have been doing all that they can to stimulate growth. Ultra low interest rates have not stimulated growth. Government bailouts have not stimulated growth. Rising government spending has not stimulated growth. Governments and central banks have already fired their ‘stimulus’ shots – and they missed.
What happens when another recession occurs? Negative interest rates? More inefficiently allocated capital from large government programs to stimulate short-term growth? At some point, the ‘cheap money’ will hit the fan.
I’m not preaching gloom and doom – I don’t think the world we live in will change drastically – but I also don’t think the current bull market will continue indefinitely. There are just too many global problems currently.
Booms and busts have occurred regularly over the last century. We have (obviously) not tamed the boom-bust cycle.
The most important thing to remember is that when asset prices fall during bear markets it is a great time to buy.
Beforehand, it may be prudent to invest in high quality dividend growth stocks which have a history of performing well during recessions. Click here to see the Top 5 bear market Dividend Aristocrats.
The worsening situation in China may be the spark that ignites another global recession… Or maybe not. As a general rule – timing the market is very difficult. It’s easy (and accurate) to say ‘things look bad’. It is virtually impossible to say ‘things look bad, and next Tuesday is when the bear market will start’.
Conversely, it’s also very difficult to time the market bottom to reinvest. In my opinion, it’s far better to buy high quality businesses with shareholder friendly managements at fair or better prices – whenever they are available, regardless of how good or bad the global economy may look.
I’m not alone in this opinion. Warren Buffett recently made the largest purchase of his investing career. Don’t miss bargains today because you are waiting for the potential of better bargains later.