Unpleasant Facts and Other Musings

Michael Pettis recently posted an interesting piece on the Shanghai market.  He makes the following points.

1. In markets, there are fundamental or value investors, arbitrage traders and speculators. Speculators react to information about supply and demand, as well as the expected short term impact of fundamental information. Value investors buy assets in order to capture the profits generated by these assets over a longer time frame.
2. In the Shanghai market, transaction costs are too high for more relative value traders.  Trustworthy fundamental information is too scarce, predicting government action is too important [This isn’t too different from the US market over the past crisis] and valuations are usually too high for fundamental or value investors to participate. This means that speculators dominate the market.
3. Without value investors buying when the market is cheap and selling when the market is expensive, the market will be more volatile.

After giving many examples of how the Shanghai market trades on non-economic information, he concludes:

“A market driven almost exclusively by speculators, and with little to no participation by fundamental or value investors, is not a market that pays much attention to long-term growth prospects.  It is driven largely by fads, technical factors, liquidity shifts, and government signaling.

So what does this year’s crash in the Shanghai stock market tell us?  It might be saying something about the impact of the European crisis on export earnings.  It might suggest that liquidity in the system is being driven into real estate rather than into stocks.  It may reflect contagion and nervousness about the fall of stock markets abroad.

But we should be cautious about reading too much into it.  In fact attempts by Beijing to hammer down real estate bubbles in the primary cities without addressing underlying liquidity expansion may simply push asset price bubbles elsewhere, and this could easily cause a surge in the Shanghai stock markets.  But this should not then be interpreted as signaling a surge in the economy.

Shanghai’s markets will go up and down, but they are not driven by investor evaluation of long-term growth prospects.  China does not yet posses the tools to make such evaluation useful, so be careful about reading too much into the stock market numbers.”

This does not mean that the Shanghai composite is useless. It means that it is a combined measure of liquidity and government intervention.  If the fund managers who speculate on government policy or liquidity are successful in making money, then the market is giving useful information. The information may be slightly different from other markets (although even developed world markets are more focused on the next few quarterly earnings than on growth prospects 5 to 10 ears out), but it is still important.  It is particularly important for those who think that China’s recent growth during the downturn is unsustainable because it is built on real estate speculation and government spending without a clear way to transition back to a more normal convergence style growth. A sharp fall in equity prices is one of the indicators of a tighter monetary policy (or that a tighter monetary policy is finally having an impact), and further extreme moves could be signs of an actual deflationary unwind. Any stock market move has many causes, but it definitely gives us useful information.

A – H share premium on top, Shanghai A Shares normalized to Jan 3^rd, 2010 on bottom. The premium of the Shanghai A shares over the foreign traded H shares is another measure of the relative excess liquidity in China’s market compared to the rest of the world. Source: Palantir.

A lot of the basic market indicators have been flashing panic signs recently. One example of this panic is the VIX, a measure of expected S&P 500 volatility over the next month, has spiked up from just over 15 to over 35 today (It hit 45 last week) in a little over a month. When the VIX is purified for recent price action in the S&P 500, the recent volatility spike suggests that people should be buying the market. However, there is increasing pressure in the financial system and buying against a panicky market while the financial system’s pressure is accelerating can be very risky.  

There are a few measures that can be used to measure financial system pressure. Equity prices and volatility, the former going down and the latter going up, are one sign. Another is credit default swaps (CDS). CDS for the average major American banks rose between 50 to 100 basis points over the past month.  A less volatile measure of market stability is the LIBOR-OIS spread. This is the spread between the rate banks lend to each other on the interbank market and the effective federal funds rate. Not only does this spread indicate stress, but according to research published by the St. Louis Fed “the LIBOR-OIS spread has been the summary indicator showing the “illiquidity waves” that severely impaired money markets in 2007 and 2008.” This time the illiquidity stress is coming from European banks exposed to sovereign risk, as well as other financial institutions that are exposed to distressed European banks (The flight to quality towards Switzerland banks caused short term interest rates there to briefly go negative, hitting -0.25% on May 25^th). 

The chart bellow shows the LIBOR-OIS, which fell through most of 2009, has rose over 20 basis points in the past month.