This week opened with somewhat of a blood bath with the Dow closing over 600 points lower on Monday. Yet despite all the fireworks, the move was actually less than 2%.
The big news that coincided with the sell off was that Chinese real estate developer Evergrande was hurtling headlong into a liquidity crisis and wouldn’t be able to service its debt.
The media picked up on the story with some labeling it China’s “Lehman Brothers” event. Others even used the “C-word”… contagion.
It’s never a good headline when any corporation ‘fesses up to the fact that they won’t be able to pay their bills or service their debts. And despite the initial news, the slide was short-lived.
By Wednesday the markets were recovering on the promise of some kind of solution, however vague…
By Thursday (as I write this) the market actually moved higher on the week.
Much was made of this whole thing.
But is Evergrande really a “Lehman Brothers” moment?
I don’t think so. Let me tell you why…
Shining “Ghost Cities” on a Hill
For years —decades even — property development has been a huge driver behind China’s economic growth. By some accounts, as much as 28% of the country’s GDP has been a result of its real estate boom.
They’ve been building at an amazing clip…
“Just how fast is China going? The country has used more cement in its construction of new cities between 2011 to 2013 than the entirety of the United States in the 20th century.”
This insane real estate boom was thought by many to mean China was on its way to becoming a global super-power to rival the United States.
Unfortunately, housing and real estate in general has always been a scam in China.
One major problem with the real estate boom was that it was based on a philosophy not unlike the voice in the movie Field of Dreams… ”If you build it, they will come.”
Many of these “shining cities” — meant to project China as a new economic leader in the world — were built based on expectations rather than demand. Even today, many developments are still waiting for residents to show up.
“According to statistics reported by the Beijing Morning Post, the number of empty apartment properties that are sitting in these Chinese ghost cities may be as high as 50 million.”
Some defenders say China is playing the “long game.” That they’re looking 20 or more years down the road. That may well be the case, but it doesn’t make China’s glorious wealth boom real today.
Something else, however, is.
Mountains of Debt
These “ghost cities” that sprung up everywhere were meant to show China’s new prosperity to the world. (It’s all about the optics…)
What is real, on the other hand, is the bottom line — the amount of debt that was incurred to build it all.
Evergrande, China’s largest real estate developer, understood this all too well. Like many businesses, they funded their real estate operations by selling various forms of debt. And like many businesses they got in way over their head.
They expanded to building electric vehicles, theme parks (Evergrande Fairyland), financial products… They spent $185 million to buy a professional soccer team and then spent $1.7 billion to build a new stadium.
The truth is, their financial crisis wasn’t breaking news. Evergrande’s problems had been public knowledge for some time. Zerohedge had been reporting on their troubles since last year.
It’s never good news when a major corporation announces that it won’t be able to pay the people it owes. (And Evergrande owed everyone… banks, investors, suppliers, contractors, and even home buyers some $300-plus billion in total.)
So, yeah it likely shook up the market a bit. But it was nowhere near the “Lehman” effect many media outlets wondered out loud.
In the first place, sure, their real estate dealings were leveraged. But they were NOT leveraged like the banking industry or financial industry was when the 2008 meltdown hit.
And secondly, there’s something else the media hasn’t reported. Corporate bond defaults in China have been hitting new highs for years…
“Chinese corporate bond issuers defaulted on about 116 billion yuan ($18 billion) in the first six months of 2021, the highest figure for any January-June period.”
So what’s the moral of this story?
First and foremost, you can’t trust Chinese regulators (the CCP).
For years they turned a blind eye as the capitalist experiment grew their wealth in the eyes of the world. In a country more concerned with optics on the world stage, this was just fine. But once they think these entrepreneurs are getting a little too prosperous… down comes the hammer.
Some bondholders are definitely going to feel a lot of pain. But this is not the equivalent of a Lehman or Bear Stearns meltdown.
So What’s Going On in the Market?
There have been a lot more important economic goings-on in the past weeks that could be blamed for Monday’s hiccup. We could talk about infrastructure spending bills and debt ceiling battles for starters.
But the truth of the matter is any significant pullback is simply long overdue.
First, the stock market hasn’t taken a significant breather of 10% or more in their current bull trend (not counting the COVID panic last year) since late 2018.
Second, right now we’re in the middle of the s****y-season for the markets.
Late September through early October are typically the worst weeks of the year for the market historically. It’s just a cyclical thing. So this negative action shouldn’t really be viewed as unexpected.
Finally, there have been a ton of indications that a pause in the rally is overdue.
Small cap stocks have been underperforming the market for months. Market internals have been soft for months as well.
So here’s an early prediction for you…
We’ll continue to see uncertainty and weakness hit the market in the coming weeks. The headlines will highlight all kinds of scary stuff asking whether the bull market is finally over. The pullback will culminate in a dip of maybe 10-15%. Then the upside will resume and we’ll be at new highs in the market by the end of the year.
So for now, you should view Monday’s mishap as pretty much a non-event.
We will, however, continue to watch more critical indicators for any significant changes and alert you should a significant change take place.
Make the trend your friend,
Co-founder, Streetlight Equity