What These Three Stocks Are Telling You About The Property Market

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If it weren’t so serious it would be hilarious. China’s attempts to blow a stock market bubble and then prop it up will prove disastrous. It will severely undermine the faith that the Chinese people have in authorities to control outcomes and protect their wealth. ‘The State’ is coming under attack.

China’s share market crashed hard yesterday, falling 8.5% in the second largest fall on record. No one really knows why, but the magnitude of the fall will hurt whatever fragile confidence had emerged over the past week or two.

Let’s back up a bit first.

China’s broader economic problems are well known. I’ve been writing about them here in the Daily Reckoning for years now. They’re perhaps best reflected in the huge credit bubble experienced from 2009–11. This led to a property and infrastructure building boom and related asset price boom.

When this boom turned to bust, China eased monetary policy to contain the fallout. Financial conditions loosened and the stock market began to take off. In their wisdom, the communists thought they could use this boom to their advantage.

They thought that the highly indebted companies from the previous boom would be able to raise capital via the stock market in order to reduce their debt. In effect, it was an attempt to get the household sector’s savings to subsidise the profligacy of the corporate and government sectors.

But households wanted in on the leverage game as well. And who could blame them? The government actively promoted the boom. Margin loans exploded as everyone tried to get rich quick using borrowed money.

But history, and common sense, shows that stock market booms built on leverage do not last. In fact, they reverse quickly, and then the leverage works in reverse.

Now the Chinese authorities are making it worse. They’ve banned insiders from selling, encouraged buying, banned short selling, and bought billions worth of shares themselves to prop the market up.

In other words, they’ve created a false market. And false markets are prone to collapse. Like you saw yesterday.

Check out the chart of the Shanghai Stock Exchange, below. As you can see, after the initial sell-off, you got the ‘dead-cat bounce’. It rallied all the way up to the moving averages, but has now turned down sharply.

By the end of the year, I wouldn’t be surprised to see the index back where this bubble kicked off in mid-2014. Who knows though? For now, understand that the path of least resistance is down. It doesn’t matter what the authorities do, they can’t reverse a bear market.

 

Where China goes from here is anyone’s guess. You’ll likely see more easing measures very soon. But will it help? One thing to keep in mind is that China is a creditor nation. Cutting interest rates (and lowering the return on savers’ deposits) is bad for consumption.

China doesn’t have many choices left. My guess is that at some point they will need to break their peg to the US dollar and devalue. The strengthening US dollar is a real problem for them, especially as Japan’s yen weakens and they lose competitiveness in the region.

Something will have to give pretty soon, and I think that it will be the currency. This is not something global capital markets expect, which means traders are not positioned for it. So any change of policy around the currency peg could cause a major bout of volatility.

For starters, who knows how much US or foreign currency debt Chinese companies hold? A devaluation could push up debt levels and servicing costs and cause stress in some parts of the financial system.

There will be winners and losers from a currency devaluation, but the authorities will have to decide which is the lesser poison. Put simply, no decision is without consequences. From here, China only has hard choices. Soon, they’ll simply have to take their medicine. That will be a good thing in the longer term. But in the short term it will hurt.

A devaluation of the yuan could also hurt Australia if it reduces capital flight out of China by reducing the purchasing power of the currency. As you know, Chinese capital is flooding into this country. It’s helping to support the property market at a time when you’d expect weaker prices on the back of slower economic growth and rising unemployment.

Of course, low interest rates provide the biggest bang for the property market. But banks are now increasing lending rates for property investors, which should soon start to affect prices at the margin.

But if Chinese capital flows also slow down, the prime property markets of Sydney and Melbourne will start to feel the effects.

There are two dimensions to this; property prices and property construction. If there is a risk of a slowdown in capital flows from China, it should start to show up in the share prices of the major property construction groups.

Below is a chart showing the performance of Mirvac Group [ASX:MGR] (black line), Lend Lease [ASX:LLC] (gold line) and Stockland Group [ASX:SGP] (blue line) over the past 12 months. All these companies have an interest in residential property development.

 

As you can see, the share prices peaked in February or March of this year. Since then, all three stocks have trended lower. What are these lower prices telling you? Has the residential construction cycle peaked? Are they discounting the likelihood of a decrease in foreign capital in the second half of the year?

No one really knows. But what I can tell you is that share prices move ahead of the news. By the time you read about something in the press, chances are that it’s already in the price.

So keep an eye on the share prices of these three large property companies. The fact that they are not making new highs despite the relentlessly bullish news on property and foreign demand for city apartments etc. should be a little troubling.

Given stocks usually discount news about 6–9 months in advance, if there’s something sinister going on you should know about it by September/October. Given these months usually produce financial market fireworks, it’s shaping up to be a big end to the year.

Regards,

Greg Canavan+,

For The Daily Reckoning, Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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