Surely I’m not the only one baffled by the market rally over the past few business days. We have analysts galore declaring “the bottom is in” and many are even suggesting that the eurozone crisis may be over with the latest bank bailout. It’s yet another example of how many investors are constantly fighting the last war, rather than the current one.
In early 2009, there was so much gloom and doom, that many US investors believed that we’d see a dead market for another decade, in spite of equity valuations that looked extraordinarily cheap even if we assumed a significant and extended depression environment. Now, it’s almost if many of these investors are determined not to make “the same mistake” twice; so they keep searching for the bottom in the latest bear market and have focused on Europe. Only problem is that the circumstances are quite different this time around.
There are some very attractive deals out there, and I find myself particularly interested in US stocks and some large, diversified international companies. It’s no secret that I’m long-term bullish on some US homebuilder stocks. And I’m finding more interesting asset plays with the recent downturn. But I don’t think this is the end of the current market dislocation by a long shot, because the eurozone bank bailout changes very little, and the market is still underestimating the severity of China's property bubble.
The Eurozone Bailout
Problem #1 is the eurozone bank bailout plan. Why do investors continue to get excited every time Nicholas Sarkozy and Angela Merkel hint at any sort of coordinated government action? Hasn’t this story replayed itself over and over and over again for the past 18 months? From the continued Greek bailout, to the outright harmful forced austerity plans, and now the bank bailouts --- none of these actions has even attempted to fix the underlying problems in the eurozone. Many (including austerity) have exacerbated the issues.
The “sovereign debt crisis” is merely a symptom of the disease; not the disease itself. The euro acts as a giant 17-nation currency peg that limits independent monetary policy in each state, and thereby creates massive trade distortions and prevents the weaker nations from ever recovering. There’s a reason Iceland is now in recovery mode after its financial crash, while Greece continues to struggle no matter what it does; Iceland was able to devalue its currency, while Greece is not, due to the euro’s flawed structure.
Cullen Roche of Pragmatic Capitalism articulates it better than I can when he says there are only two options: for the eurozone to split or for the nations to fiscally integrate and create a “United States of Europe,” if you will. The problem cannot be solved by merely bailing the banks out. In fact, if the eurozone plans to enact a bank bailout plan without fixing the underlying issues inherent with the euro, it could actually make the problems worse.
If people are buying into the rally because of the latest eurozone agreement, they are buying in for the wrong reasons.
China’s Property Bubble
The other problem with the “bottom is in” thesis is that this is merely the tip of the iceberg when it comes to China’s property market collapse. This is a thesis that famed short-seller Jim Chanos has been beating the drum on for two years now and the crisis has played out almost exactly as he has suggested it would.
Housing prices in Beijing fell 6.6% year over year, according to the most recent data. More alarmingly, the number of residential units sold in Beijing fell a whopping 62% year over year. We saw hints that this pattern was beginning in Hong Kong this summer, and it has started to spread rapidly. Given that 70% of China’s economy is dependent on fixed asset investment, this could be a massive disaster, destroying jobs for a large chunk of the Chinese population. I also wouldn’t be shocked if the PRC ends up insolvent when all is said and done.
China’s recent foray to buy more stock in the state-owned banks will not prevent the real estate market’s collapse, and I would view their quickness to action to suggest that this problem is much, much larger than they are letting on. One way or another, it’s going to be difficult for the Chinese government to contain this.
Many people have argued that the power of China’s Communist Party allows the government to respond to these crises with much greater ease than Western liberal democracies, but this argument misses the point. China’s property bubble developed precisely because the Communist Party’s heavy-hand in all aspects of the economy.
The currency peg has created a centralized policy in favor of export-led growth, at the expense of consumer purchasing power. This has created a giant misallocation of resources, with too much export capacity, massive inflationary problems, and an economy that doesn’t cater to consumers very well. By combining all of this with artificially low interest rates and a government-induced lending spree, China pushed more and more investors into housing and gold, in order to try to preserve their wealth against rising inflation. Ultimately, however, if there was not enough underlying demand for those properties, then it was bound to lead to a deflationary crash; which is what might be starting already.
The World Benefits?
The one area I disagree with many China property bears on is the ramifications for the world economy. Many people view China as the world’s “growth engine,” which is a flawed analysis, in my view. Rather, China has made the same mistake as Japan, and when it appeared that its rapid growth was starting to weaken, it used easy credit to maintain the growth. But this growth was not sustainable, and ultimately, harmful to the broader world economy.
It’s worth noting that the world economic boom of the 1990s only occurred after the Plaza Accord and the collapse of the Japanese Asset Bubble. Currency pegs and other mercantilistic intervention policies tend to reduce the overall volume of world trade and create economic inefficiencies, thereby sapping worldwide economic growth.
Just like Japan’s mercantilistic policies of the ‘70s and ‘80s may have helped create economic instability, China’s currency peg, coupled with its easy money policies, has helped stalled growth and create instability in many parts of the world. Overall, since the peg creates a mismatch of resources, it is harmful to global trade. In the long-term, the collapse of China’s bubble is actually beneficial to the world economy.
There are Opportunities
I should reiterate that there are many opportunities out there right now, and this is the first time I’ve been excited about what I’m seeing in the markets since ‘09. But I’m not necessarily convinced that “the bottom is in,” as the market may be severely underestimating the issues in China and the eurozone.
I favor US stocks right now and believe that they are, generally speaking, a great long-term buy, but could continue to suffer in the short term due to problems around the globe. At some point, I believe the US market will start to ‘detach’ itself from those issues, but I’m not sure when that occurs and we may need a few more headline shocks first. Regardless, buying in because of the eurozone's bank bailout plan is the wrong reason to buy in.
Disclosure: Author is short and owns long-dated put options on FXI.