Comes word this morning that the China State Construction Engineering Company has gone public. It’s the biggest public offering – at $7.3 billion – in more than a year. It’s also China’s biggest homebuilder. And as soon as the shares hit the market yesterday they soared…closing 56% higher than the IPO price. At that price, it trades at about 40 times forecast 2009 earnings.
Why would you pay 40 times earnings for a homebuilder? It’s a fairly easy business to enter. No barriers to entry that a little money…a few connections…and a circular saw can’t overcome. With no barriers to entry, profit margins are always squeezed by competition. And growth is limited too – other builders are always starting up. If the investor paid 40 times earnings, he can only get 2.5% on his money – if the company pays out 100% in dividends! So, why pay so much?
The answer has two parts. First, China is providing stimulus to its economy on a mammoth scale. It gave the signal to its banks. The banks responded by opening the flood gates. Loans in the first half of the year measured three times those of the same period a year before. Naturally, this liquidity had an effect. The economy is booming. Everything credit can buy is being bought. But, as we at Markets and Money know, you can’t buy real prosperity on credit.
And the other reason for the bubble in builders’ shares? Investors – especially investors in China – have learned nothing from the crash of ’07-’08.
These are our little secrets, aren’t they, Dear Reader? The rest of the world seems unaware of how the investment markets work…and they think credit is Miracle-Gro for the economy.
But markets are not mathematical…nor mechanical; they’re moral. Their purpose is not to make people wealthy, but to make them wise. And then…only for a while.
It they were mathematical you might make people richer by adding zeros. But it’s not that simple. Zimbabwe tried it; it doesn’t work. A Dear Reader gave us a $10 TRILLION dollar bill – real money printed by the Zimbabwean Treasury. That – and about $5 US dollars – will buy you a cup of coffee in Harare…if they have any.
If they were purely mathematical, you might be able to anticipate price movements with computers and PhDs in math. Many have tried it. As far as we know, none has ever really succeeded.
It’s not a mechanical system either. When prices go down, there are no screws you can tighten…no levers you can pull… Nor can you add more fuel or slather on more grease. It’s not that simple.
Instead, markets are complex natural systems. Like mistresses, they can be jiggled and jived… but they can never really be controlled or predicted. That’s what makes them so interesting, of course.
The markets are always teaching us…always correcting us…always giving us a kick in the pants. These are moral lessons…in the broad sense. That is, if you do the wrong thing you get punished for it. Step on a rake; it hits you in the face.
The purpose of a bear market is to correct the errors of the preceding boom. Most prominent among those errors is to think you can make money by speculating in the stock market. When this idea takes hold, good sense goes out the window. People will buy dotcoms with no business plans…and house builders at 40 times earnings!
But that’s how we’ll know when the correction is over – when people give up on the stock market…when they want nothing more to do with it. Judging by today’s news…we’re still a long way from there.
Get ready for another crash…the next leg down of this historic correction…the next kick in the pants…the next moral lesson.
If investors have learned nothing so far…neither have the feds. All over the world they’re trying to solve a problem caused by too much credit by providing more credit. Trillions’ worth, in fact…
We see the result of it in China…a country where the feds have money to spend…and the power to tell bankers what to do. The markets have gone wild…
In the United States and Britain, they’ve been less successful. But they haven’t given up. On the contrary…they’ve put at risk an amount equal to nearly twice the GDP of the entire US economy…and now they’re talking about Stimulus II…
Then Stimulus III…then Stimulus IV will probably follow…until the whole thing finally explodes in a blaze of glory…
Consumers have wised up. They seem to have learned their lesson. Savings rates have gone from zero to 7% in the past 12 months – a remarkable turnaround. Frugality is back in fashion. Thrift has been put back in the dictionary. Consumers are tired of carrying huge debt loads. They’re eager to get rid of them as soon as they can.
But neither Wall Street, nor Washington, nor investors seemed to have learned much. Wall Street is still handing out billions in bonuses – leaving its firms short of capital reserves. Investors still seem ready to jump onto whatever wagon has the most other people on it. And while the private sector ran up trillions in debt in the bubble years; now, it’s the public sector’s turn.
In 1991, borrowing by government and the private sector put together was less than 5% of GDP. But by 1998, the private sector was on a binge. Every year for the following decade, households and businesses borrowed between 10% and 15% of GDP, while government continued to borrow modest amounts…less than 5% of GDP.
In 2008, the positions reversed dramatically. Private sector borrowing collapsed to below zero – meaning, the private sector was is paying off debt, not accumulating more of it. The public sector, on the other hand, has come to the rescue with borrowings between 10% and 15% of GDP.
Of course, this is classic counter-cyclical stimulus. What the private sector giveth up on…the public sector taketh up like an unexploded hand grenade. The politicians are now pulling the pin…
Yes, dear reader, there are still lessons to be learned.
But wait…isn’t counter-cyclical stimulus a good thing? Everyone says so. Without it, said Ben Bernanke, we might have entered a Second Great Depression. And we don’t know…maybe he’s right. The private sector is no longer borrowing and spending like it used to; now, the feds have to do it, right?
Where have you been, dear reader? That’s not the way it works. The credit explosion in the bubble years didn’t really make households richer – it made them poorer. That’s why they’re struggling to pay their bills now. And the credit explosion in the public sector now isn’t going to make people richer either; it’s going to make them poorer too. Soon, the United States will be struggling to pay its debts too.
That’s the moral lesson: borrowing makes you poorer. Unless you’re using the money to increase output, there’s no economic health it in. In other words, if a factory sees an opportunity, it might borrow to expand. The extra output should produce enough profit to allow it to repay the loan…and come out ahead. But if you borrow to consume, at the end of the day you’re poorer. That’s the lesson of the Bubble Years. That’s the lesson consumers need to learn every couple of generations. And now, they seem to have learned it. They remember that the economy ran hot in the bubble époque, but it didn’t do them any good. And while the stimulus of that era did stimulate consumption, it was not genuine wealth building.
And now cometh the feds. They’re borrowing and spending on a scale never before seen. The federal deficit is expected to come to $2 trillion this year. Trillion-dollar deficits are foreseen for the next 10 years. There seems to be no way out.
What the private sector took away – about $1.4 trillion of debt-induced spending – the public sector puts back. But will this spending produce any more real wealth than the private sector binge? Let’s see…the news reports tell us they are using it to fix toilets in national parks…cut down pine trees in rural Tennessee…and bail out the bankers on Wall Street. Is this consumption or investment? If it is investment, is it wise investment? It’s not enough to invest; you have to put money into projects that pay off…that pay dividends…projects that give you the cashflow to pay back the debt! Will federal spending for the stimulus/bailout projects do that?
Don’t even wait for the answer, dear reader; you already know what it is.
Tomorrow…the vigilantes are back…the real showdown…
Until next time,
for Markets and Money