Everything You Need to Know About Freaky Friday

04/17/2015 4:37 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

MoneyShow’s Jim Jubak highlights how tighter margin rules in China led to a global sell-off in stocks.

On the one hand, today’s drop in US and global stocks is the result of a freaky coincidence.

On the other hand, it is a reflection of stock markets—especially in China—that had gotten way ahead of their fundamentals.

Which makes it hard to tell whether this is a one-day event or marks the beginning of a longer pull back.

I’ve been cautious going into earnings season and I certainly don’t see anything in today’s drop to make me less cautious. I’d certainly let the dust settle in China; that market has been expecting stimulus and it got the opposite today. And I’d be on the lookout next week to see if the positive sentiment in the front half of this week in US stocks has changed. In Europe, the Greek debt crisis looks like it’s coming to another head, with an April 24 meeting of EuroZone finance chiefs likely to increase tension. If you’ve got cash on the sidelines, I think it’s worth hanging onto it to see if today’s break continues next week. I went into earnings season looking for a bargain or two. So far, I haven’t seen any on the news, but I’m looking to see if that might be about to change.

Anyway…

The freaky coincidence is actually very freaky. Overnight, Chinese regulators banned the margin units of Chinese brokerages from using umbrella trusts. Margin debt used to buy stocks on the Shanghai market soared to an all time record of 1.16 trillion yuan ($187 billion) on Thursday, April 16. Umbrella trusts allow investors to increase their leverage even further. Private investors in the trust buy the junior tranche while cash from bank wealth management products take the senior tranche. The senior tranche receives a fixed return while private investors take the rest. That effectively turns investors in the junior tranche into borrowers from the banks, since they get any extra gains without putting up extra money. So these private investors in these umbrella trusts gain the opportunity for big leveraged gains and big leveraged losses. China’s trusts boosted their investment in stocks by 28% to 552 billion yuan ($89 billion) in the fourth quarter.

With the Shanghai market up 78% since October 2014, and with hopes of further stimulus measures from the People’s Bank of China—after a report of just 7% growth in first quarter—likely to provide even more fuel for traders, the huge increase in buying on margin was just too much for regulators. (Traders in mainland China have so far in 2015 opened a total of 10.8 million new stock accounts; that’s more than in 2012 and 2013 combined.) Besides the ban on brokerage margin units using umbrella trusts, on Friday, regulators also announced that they would permit mutual funds and private asset management plans to lend shares to short sellers. Regulators expanded the number of stocks eligible for short selling to 1,100 from 900 previously. China has permitted lending shares to short sellers since 2010, but short selling has been limited by the small number of shares available for borrowing.  Short selling reached a record 7.47 billion yuan last week, a drop in the bucket compared to 1.17 trillion in margin debt.

All this took place after the stock markets had closed in China—the Shanghai Composite, in fact, climbed another 92.47 points or 2.2% on Friday—but in afterhours trading, futures on the Hong Kong’s Hang Seng index fell more than 2%.

Now here’s where the freaky comes in. At about 8:20 AM London time, a network outage hit Bloomberg terminals and restricted the ability of many traders to see what was happening in Hong Kong and to conduct trades. That led to a big drop in market liquidity. Service was restored by 12:45 PM London time but that was enough to point the day in a negative direction, with futures on the S&P bottoming at around 6:30 New York time.

While all this confusion was hitting the markets from China, the European markets were adding their own negative news to the mix. The yield on the 10-year German government bond fell to 0.05%. That drop—0.05% on 10-year money!—raised fears that a Greek default could happen as early as May when the country faces repaying 1 billion euros to the International Monetary Fund. Yesterday, the head of the IMF, Christine Lagarde, said that her institution would not extend the deadline for the Greek repayment. (Greece had made an informal request for an extension, according to the Financial Times.) The IMF has not extended a repayment deadline for a developed country ever and hasn't extended a deadline for anyone in 30 years, she noted. Meanwhile, it looks like the April 24 meeting of the Eurogroup will come and go next week without action on releasing the 7.2 billion euros that Greece has been promised, if it can present a detailed plan for economic reforms.

The German DAX stock index closed down 2.58% today and the Spanish IBEX finished down 2.17%. European indexes have been at or near all time highs in 2015.

The selling in Europe hit a US market with its own recent uncertainties. The Standard & Poor’s 500 had retested resistance from the trend off the February and March highs on both April 15 and April 16 and been unable to move above that ceiling. All things else being equal, that left the market in a neutral position in terms of sentiment and momentum. But, of course, the day didn’t begin with all things being equal.

As of 3:00 PM New York time, the S&P 500 was down 1.43% and the Dow Industrial Average was down 1.75%.

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