Did you see what happened in Hong Kong overnight?
The major Hong Kong Index, the Hang Seng was down slightly, dropping 0.54% on the session.
But a smaller group of stocks in the Hong Kong market got slaughtered. Jiayuan International Group, Sunshine 100 China Holdings and Rentian Technology Holdings. fell over 75% in a matter of minutes and at least 10 stocks were 20% lower or more by the close. The plunge in those shares wiped out HK$37.4 billion ($4.8 billion) in market value. The biggest loser was Jianyuan International, which dropped HK$26.3 billion on record volume.
If you’re like me, you’ve never heard of these companies and you don’t own shares, so why should you care.
Because the downdraft came because of structural weakness in the Hong Kong market–and one thing that keeps me worried about a resurgence of the bear market in U.S. equities is structural weakness in the domestic market.
One likely explanation for the drop in Hong Kong is a high degree of cross-shareholding where companies own each others share and use those shares as pledges against liabilities. Once selling starts in one of those cross-holdings, all the connected parties look to sell tool.
In addition, rules on the Hong Kong exchange say a controlling shareholder can borrow against shares and not disclose the loan as long as it’s for personal finance reasons rather than for corporate purposes. loans, guarantees or other forms of support for the company.
Something like the overnight plunge took place in 2017 when a network of 50 interconnected stocks triggered a cash that wiped out $1.4 billion in market value from five small-cp stocks in November.
The Hong Kong market isn’t alone in having this “interconnectedness” problem. It’s true of mainland Chinese markets as well (and in Japan.) The Chinese problem and danger may be even bigger since it involves bank lending on interconnected collateral and loans from local governments.
So one thing that worries me is that the economic stresses in the Chinese economy and banking system could result in a larger version of this overnight sell off–large enough so that volatility in China’s financial markets would unsettled emerging markets in general.
The other thing that worries me is that while the United States financial markets don’t have this kind of “interconnectedness” problem, there are reasons to be concerned with the huge financial concentration in a handful of stocks, such as Amazon (AMZN) that are owned by, seemingly, every ETF in the financial universe. There’s also the problem of the huge increase in corporate debt with disclosure and covenants much weaker than, say, five years ago.
The global financial crisis may look explicable in retrospect, but at the time it seemed unthinkable that a problem in the sub-prime mortgage market could send the global financial system into crisis.
In the next crisis, whenever it may be, we aren’t likely to see the source of the problem until it bites us.
So, despite the losses I’ve taken on my Put Options in Amazon, Netflix and other short hedges (including my Call Options on the VIX volatility index), I’m not putting these tools away quite yet. I’m going to post another worry or two later today.