The recent performance of the Shanghai Stock Exchange has been amazing and frightening.
It clearly shows that financial bubbles can occur even when there are clear warning signs and plenty of historical evidence to help identify bubble characteristics.
These warnings include asset price appreciation, trading volume, new issues and margin debt or borrowings.
One of the remarkable features of the Shanghai Stock Exchange was its stability between 2010 and the end of last year. The 2014 year index close was 3235, which was close to the 2010 year high of 3307.
But the market began to pick up last November and the Shanghai Composite Index rose 10.8 per cent during the month on trading value of US$797 billion. This compared with trading values of less than US$300 billion a month during the first half of the year.
The market really took off in December, when the index soared 20.6 per cent on trading value of US$1.8 trillion.
The start of this year was also frantic, particularly between March and May, when the index soared 39.3 per cent, with an average monthly trading value of US$2.5 trillion.
During this period the Shanghai market was the world’s busiest stock exchange by a wide margin. Its trading value was 1.8 times that of the New York Stock Exchange (NYSE) and 2.4 times that of the Nasdaq.
Usually, it is the other way around – Shanghai had only 0.3 times the NYSE trading value in 2013 and 0.4 times the Nasdaq trading value over the same period.
The benchmark Shanghai Index soared 162 per cent from its March 2014 low to a high of 5178 on June 12 this year.
Meanwhile, the number of IPOs went from zero in 2013 to 43 last year and 66 in the first five months of this year.
Increased IPO activity is a clear sign of an overvalued market, particularly when many of the new listings are of low quality as they were in New Zealand in the mid-1980s.
Reports from China indicated that recent new launches have been overhyped, the quality of the new issues has been low and unsophisticated investors have been major participants in the new issues market, both before and after listing.
There has also been a huge increase in margin debt – buying shares with borrowed money.
Official estimates show this represents 8.5 per cent of the Chinese sharemarket’s free float, compared with margin debt of less that 3 per cent of the New York Stock Exchange free float.
Chinese commentators believe that margin debt is much higher than 8.5 per cent.
The Chinese Government and other official agencies have introduced a number of initiatives to stop the sharemarket slide.
Scheduled IPOs have been cancelled.
A large number of stocks have been suspended from trading.
The state-owned investment organisation Central Huijin has bought exchange traded funds and will continue to do so.
Chinese state-owned enterprises have been ordered not to sell shares and to buy oversold stocks.
Large brokerage firms have created a fund to invest in the market.
The People’s Bank has provided liquidity support to China Securities Financing Corporation which will use this money to fund brokers offering margin debt.
Qualified insurers may now invest up to 10 per cent of their total assets in a single blue chip company compared with 5 per cent previously.
These moves are encouraging but the Chinese Government should never have allowed the market to get so overheated in the first place.
Margin debt was strictly regulated and almost non-existent in China until 2010. These margin debt rules have been substantially relaxed over the past five years and this has been a major contributor to the Shanghai market’s meteoric rise and enormous trading volumes.
Margin debt has been the root cause of a large number of sharemarket booms and busts over the past 100 years.
Shades of the 80s with Marlborough Lines Co’s stake in wine company
The acquisition of 80 per cent of Yealands Wine Group by Marlborough Lines Company is a worrying reminder of the 1980s when manufacturers purchased kiwifruit farms, mining companies bought retailers and fitness centres got into property development.
Most of these transactions were not successful in the longer term.
Marlborough Lines was formed as the Marlborough Electric Power Board in 1923. In 1993 it was corporatised, renamed Marlborough Electric and its shares were vested to the Marlborough Electricity Power Trust.
This was a body specifically created to hold the Marlborough Electric shares on behalf of electricity consumers and to appoint commercial directors in place of the originally elected board members.
In 1998, after Marlborough Electric was forced to divest its generation assets, the company became an electricity network owner and operator and changed its name to Marlborough Lines.
One of Marlborough Lines’ most prominent features is its excellent annual report. It is far more detailed than that of many listed companies and the company is also more profitable than NZX-listed Horizon Energy, the network operator that services Eastern Bay of Plenty.
The Blenheim-based company reported earnings before interest and tax (ebit) of $12.4 million for the June 2014 year. Horizon had ebit of $9.4 million for its March 2015 year.
Marlborough Lines has three main operations:
• It directly supplies 24,500 customers in Marlborough.
• It has a 50 per cent interest in Nelson Electricity, which supplies the central Nelson city area.
• It has a 13.9 per cent stake in Horizon Energy, which has 24,600 customers in the Bay of Plenty.
The Blenheim-based company is flush with cash after it sold its 51 per cent interest in OtagoNet and Otago Power Services for $152 million late last year. These assets were originally purchased for $55 million in 2003.
On July 2, Yealands Wine said Marlborough Lines had agreed to buy 80 per cent of the company from Peter Yealands for $89 million.
This was contrary to a bold headline in a recent annual report that “The Marlborough Lines Board has a strong preference for investing in electricity networks rather than other non-core investment options”.
There has been a mixed response to the purchase but the Marlborough Electricity Power Trust, which owns Marlborough Lines, said it was satisfied with the transaction.
The buy has been criticised for several reasons including:
• It is outside the company’s core competencies.
• Two Marlborough Lines directors, Anthony Beverley and James Hay, resigned a few days before the deal was announced.
• Peter Radich, who is listed as Marlborough Lines’ solicitor in the company’s annual report, is a director of Yealands Wine Group. Radich said he had no involvement in the sales process.
It is difficult to know whether this is a good investment for the lines company but Peter Yealands had a huge smile when photographed celebrating the transaction with Marlborough Lines managing director Ken Forrest.
The big question is – should an electricity lines company be spending $89 million on the purchase of an 80 per cent stake in a wine company or should this $89 million be distributed to customers, which would result in a payment in excess of $3,500 to every customer?