A woman walks past an electronic board showing Hong Kong share index outside a local bank in Hong Kong, Monday, Sept. 12, 2016. Regulators are looking into a mysterious group of companies known as 'The Enigma Network' after a sudden unexplained stock market crash. (AP Photo/Vincent Yu)A woman walks past an electronic board showing Hong Kong share index outside a local bank in Hong Kong, Monday, Sept. 12, 2016. Regulators are looking into a mysterious group of companies known as 'The Enigma Network' after a sudden unexplained stock market crash. (AP Photo/Vincent Yu)

A mysterious crash within an obscure corner of the Hong Kong Stock Exchange has elicited regulatory scrutiny, fanned rumors of conspiracy, and renewed calls for changes in the city’s financial markets.

Over a period of two days in June—June 27 and June 28—a handful of small-cap stocks fell dramatically, wiping out around $6 billion in market value. The hardest hit stock was down more than 90 percent intra-day, and 13 stocks fell at least 50 percent on June 27.

Although impact from the sudden crash was isolated, the decline has hit hard Hong Kong’s small-cap exchange Growth Enterprise Market (GEM). As of July 7, the S&P/HKEX GEM index is down 21 percent since Jan. 1, and 11 percent since June 26.

The recent crash in Hong Kong small caps underscores the reputation for wild swings at the Hong Kong Stock Exchange (HKEX) and its subsidiary GEM. Although HKEX is producing solid returns this year—the Hang Seng Index is up 15 percent—some individual stocks have experienced high volatility. For instance, China Huishan Dairy Holdings Co., one of China’s biggest diary producers listed in Hong Kong, saw its stock drop more than 85 percent in one day in late March, prompting the exchange to suspend trading of its stock.

‘The Enigma Network’

But there’s something unsettling about the nature of the two-day market crash in late June.

A dozen of the stocks that experienced catastrophic crashes on June 26 and 27 were all part of a group of companies called out by Hong Kong-based independent stock analyst and gadfly investor David Webb.

Webb identified them as part of “The Enigma Network,” the name he gave a web of 50 Hong Kong-listed companies with significant cross-ownership. Webb, a former board member of HKEX, urged investors in May not to purchase stocks on the list due to their opaque structures and balance sheet disclosures.

The Engima Network

The Enigma Network: 50 stocks not to own. (webb-site.com)

Companies within “The Enigma Network” hold stakes in each other from less than 1 percent to more than 50 percent. The companies in the group span multiple industries across real estate, finance, and consumer products, including umbrella maker China Jicheng Holdings Ltd. and GreaterChina Professional Services Ltd., the pending owner of English football club Hull City FC. Both Jicheng and GreaterChina saw their shares sink more than 90 percent during the June crash.

Webb, who has studied Hong Kong stocks extensively, first suspected the correlation and began to connect the dots after noticing balance sheet disclosures of “financial assets” with no additional detail at numerous companies.

The picture came into focus as the companies increased their financial disclosures after Webb “began filing complaints with the Stock Exchange that the for-profit regulator had failed to enforce a listing rule which requires annual and interim reports to disclose ‘significant investments held, their performance during the financial year, and their future prospects.’”

The cross-holding was confirmed after one of the “Enigma” companies, Amco United, a medical device maker, issued a profit warning on June 28 to investors that a “substantial loss” is expected in the first half of 2017 due to its ownership in other listed securities.

This has also caught the attention of regulators. According to Bloomberg, Hong Kong’s Securities & Futures Commission (SFC) said the affected stocks “tended to have characteristics that can be conducive to extreme volatility and to market misconduct: multiple relationships between different companies and listed brokerage firms, high shareholding concentrations, thin turnover, and small public floats.”

The SFC did not confirm or deny whether there’s an investigation into the June crash.

Lerado Financial

A common thread among a few of the biggest decliners appeared to be Lerado Financial Group Co., a Hong Kong-based securities brokerage that’s currently under regulatory investigation. Lerado on June 27 disclosed that it had sold 1.48 billion shares of China Jicheng—no doubt contributing to Jicheng’s crash on the same day.

Lerado itself has been under scrutiny. Its shares were suspended from trading beginning June 6, on allegations that a company circular dated Oct. 26, 2015 included “materially false, incomplete or misleading information,” according to SFC, the Hong Kong securities regulator.

In Lerado’s 2015 document, the company disclosed fundraising plans to expand the margin lending business of its subsidiary Black Marble, which had planned to underwrite a share placement for GreaterChina Professional and an open offer for China Investment & Finance Group Ltd., according to TheStreet.com.

Shares of GreaterChina Professional fell more than 90 percent on June 27. China Investment & Finance shares dropped 52 percent on June 27 and 46 percent on June 28.

An obvious theory for the crash of these stocks is that the owner of Lerado—whose shares have been suspended from trading—needed to raise money to meet a margin call or some other obligation and the only way to do so was to dump the shares of Lerado’s underlying investment holdings.

Other theories abound. One hypothesis—proposed by a South China Morning Post columnist—suggests the crash was orchestrated by a pyramid schemes in mainland China linked to Hong Kong penny stocks.

Chinese Anti-Corruption Links

The HKEX and GEM market turbulence could be linked to ongoing regulatory overhaul within China’s financial sector. The activities of some of China’s biggest overseas acquirers have recently been curtailed, and a few influential financial and regulatory leaders were placed under investigation by anti-corruption watchdogs.

David Chung Wai Yip, chairman of GreaterChina Professional, was arrested on April 20 by Hong Kong Independent Commission Against Corruption according to a statement by the company.

Regulatory clampdowns on mainland Chinese stockbrokers could also have contributed to the Hong Kong volatility. “As capital was tightened up, some stock dealers might demand more money from clients because of limited supply. It ended up that one company didn’t get enough capital, resulting in a domino effect,” Zhiwei Zhang of Prudential Brokerage Ltd. told The Epoch Times.

Zhang also saw a connection between the investigation and Chinese leader Xi Jinping’s crackdown on outbound capital flows. “It could be that they want to tidy up the stock market before July 1… and also to crack down on the disloyal and corrupt guys; that’s another possibility.”

Small-Cap Governance

Recent HKEX and GEM volatility have renewed calls for greater regulatory oversight within Hong Kong’s financial markets—the world’s fourth largest.

In particular, small-cap exchanges such as Hong Kong-based GEM, U.S.-based OTC Markets, and London-based AIM have long been criticized for being a haven for unvetted, often fraudulent companies.

For example, HKEX and GEM could use better rules to combat shell companies, whose stock could jump on expectations they will be acquired by Chinese firms for backdoor listing—acquiring an existing Hong Kong-listed entity to circumvent stringent filing and disclosure requirements. Such stock gains are purely speculative and not grounded in economic fundamentals.

There’s evidence authorities are about to take action. HKEX recently proposed a review of GEM and changes to stock listing requirements, according to a notice to seek public comment filed June 16.

The proposals, among other changes, seek to address critical issues related to “quality and performance of applicants to, and listed issuers, on GEM.”

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A trader talks on the phone at the Hong Kong Stock Exchange on July 9, 2015. (Isaac Lawrence/AFP/Getty Images)A trader talks on the phone at the Hong Kong Stock Exchange on July 9, 2015. (Isaac Lawrence/AFP/Getty Images)

New York has displaced Hong Kong as the world’s top destination for initial public offerings (IPOs) of stock during the first three months of 2017.

A lack of major stock offerings sent Hong Kong—the main Stock Exchange of Hong Kong (HKEX) and the Growth Enterprise Market (GEM) combined—to a distant fourth place, behind New York, Shanghai, and Shenzhen.

Global IPO activity was brisk overall in the first three months of 2017, with 369 total global IPOs raising $33.7 billion in proceeds, according to EY data. The proceeds are a 146 percent increase from the same period in 2016.

The New York Stock Exchange led the way with $9.6 billion in total value from 14 issuances during the first quarter. Hong Kong’s $5.3 billion in first quarter IPO value was an 11-year low, according to data from Thomsen Reuters.

Hong Kong was the leading destination for company stock offerings in 2016 and 2016. Last year, it hosted $25 billion in total listing value and 115 deals. Its 2016 listing value was almost double that of New York, which listed $13.6 billion of IPOs, according to data compiled by EY.

Allowing Dual-Class Shares

Hong Kong’s lackluster IPO market share so far in 2017 could accelerate listing rules reform by the Hong Kong regulators.

EY_IPOs

(Source: EY)

Hong Kong Exchanges and Clearing chief executive Charles Li announced at a press conference in early January that the exchange is consulting stakeholders on the launch of a third stock exchange in Hong Kong in addition to the main HKEX and technology-focused GEM, according to the South China Morning Post.

The most-talked about reform will likely be the allowance of dual-class share structure. Dual-class structure, which allows companies to have two classes of common stock with different voting rights, is popular with startups but is currently banned by Hong Kong exchanges. The allowance of dual-class listing was proposed by the Hong Kong exchanges back in 2014, but it was ultimately rejected by the Securities and Futures Commission, the city’s securities regulator.

A single mega-IPO could often swing the fortunes of a stock exchange.

A third stock exchange in Hong Kong, if approved, would likely host companies with dual-class share structures.

Blockbusters Determine Winners

Hong Kong’s rise as a leading global IPO destination over the last few years has been a product of increased IPOs of Chinese companies looking to expand their access to capital by tapping foreign investors. Prior to establishment of the recent Hong Kong-Shanghai and Hong Kong-Shenzhen stock connect portals, foreign investors had limited exposure to Chinese companies.

The IPO of a single major company could often swing the fortunes of a stock exchange. In 2014, Chinese e-commerce giant Alibaba Group Holding chose to list on the New York Stock Exchange instead of Hong Kong, specifically because Hong Kong exchanges rejected Alibaba’s dual-class share structure. Alibaba’s historic $25 billion IPO, which was the biggest ever, single-handedly propelled New York to the top of IPO rankings in 2014.

While the Asia-Pacific region led the way in IPOs during the first three months of 2017, activity was spread across several regions. Greater China was the busiest, followed by Japan and Australia. The biggest Asia IPO by proceeds was that of media company Sushiro Global Holdings Ltd., which raised $611 million in Tokyo.

The United States will likely challenge Asian exchanges for IPO superiority during the rest of 2017 due to several highly anticipated technology IPOs. AirBNB, Palantir Technologies, and Uber are all 2017 IPO candidates following Snapchat’s successful $3.9 billion IPO in March.

Last year was an especially underwhelming year for the U.S. IPO market. This was mainly due to lackluster stock market performance during the first half of the year and the mid-year shock of U.K.’s decision to leave the European Union. After a slight bounce back, investors were skittish ahead of the U.S. elections. The volatile market conditions of 2016 forced some companies to push back their IPO plans.

The biggest U.S. IPOs in 2016 were cross-border IPO of Chinese logistics company ZTO Express, insurance company Athene Holdings, and real-estate investment trust MGM Growth Properties.

Next year may become the biggest IPO year ever. Determination of 2018’s top IPO destination will likely rest on how Saudi Aramco chooses to list its shares.

Saudi Aramco is Saudi Arabia’s state-owned oil company. As part of the Kingdom’s plans for privatization, Saudi Aramco is exploring a 5 percent share offering in 2018. With an overall valuation of up to $2 trillion, Aramco’s 5 percent IPO will likely become the biggest in history, raising up to $100 billion in proceeds.

The Saudis are exploring several listings across the United States, Asia, U.K., as well as locally on the Tadawul Stock Exchange in Riyadh. How Aramco decides to allocate its massive stock sale will determine 2018’s top global IPO destination.

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NEW YORK—Tumult in China triggered the worst opening week for U.S. stocks in history, and this week investors could get plenty more to worry about.
Profits are expected to drop at U.S. companies.
Again.
Earnings for companies in the Standard and Poor’s 500 index are forecast to drop for the second straight quarter, a rare occurrence outside a recession. Despite a rebounding jobs market, the United States did not grow fast enough to boost profits, and once surging developing economies that helped lift foreign sales slowed dramatically.
Despite a rebounding jobs market, the U.S. did not grow fast enough to boost profits, and once surging developing economies that helped lift foreign sales slowed dramatically.

All this would be worrisome enough at any time, but investors are particularly jittery now. U.S. stocks are expensive by some measures, even after slipping in 2015 and falling sharply in the first week of the year. That leaves little room for more disappointing news.
One widely respected gauge, the so-called Shiller earnings ratio, is flashing warning signs. Named after Nobel Prize winner Robert Shiller of Yale, the ratio compares the price of stocks to annual earnings averaged over 10 years. The measure is now 25, much higher—meaning more expensive—than the long term average of 18.
“When expectations are as high as they are, that’s a problem,” says Jack Ablin, chief investment officer of BMO Private Bank.
When expectations are as high as they are, that’s a problem.— Jack Ablin, chief investment officer, BMO Private Bank

Companies begin reporting their results for the October-December quarter on Monday. Earnings per share for the companies in S&P 500 is expected to have dropped 5.5 percent compared to a year earlier, according to S&P Capital IQ, a research firm. That follows a 1.4 percent drop in the July-September quarter. Revenues are forecast to fall for a fourth quarter in row.
This wasn’t supposed to happen.
A year ago the average view of financial analysts who follow the stock market said earnings for the October-December quarter would jump 12 percent, and urged investors to buy accordingly.
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Analysts on Wall Street are a notoriously bullish bunch, but you can almost understand their enthusiasm. Since the financial crisis, U.S. companies have managed to squeeze profits out of a slow-growing domestic economy. They slashed costs, often through massive layoffs, and restructured their businesses to operate faster and smarter.
They were also helped by surging sales abroad, super-low borrowing rates thanks to Federal Reserve policy, and a controversial maneuver: Companies bought trillions of dollars of their own shares to take them off the market. Investors love the maneuver, because it spreads earnings over fewer shares and boosts earnings per share. But critics point out that the purchases can make companies seem more successful than they actually are.
The result of all this corporate scrambling, shrewd or short-sighted, was a booming stock market. The S&P 500 more than tripled from its 12-year low in 2009 through its peak in May. Even after last week’s drop, its biggest since September 2011, the index is just 6.5 percent below that level.
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The problem now is that it is difficult for Corporate America to cut costs any more, and the rest of the world is slowing and can’t help out. Japan, the world’s third largest economy, barely grew last year, Canada briefly dipped into recession and Brazil and Russia are struggling to escape ones. On Wednesday, the World Bank lowered its forecast for global economic growth this year to a feeble 2.9 percent.
The good news is that some parts of the U.S. economy are doing well. U.S. households have cut debt and saved more since the financial crisis. The housing market is solid. And there are more jobs. On Friday, the Labor Department reported that employers added 292,000 workers in December, capping a robust year of hiring.
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But after years of sub-par economic growth, many economists are skeptical the U.S. economy, and corporate results, are about to take off.
“It’s going to be harder and harder to produce solid earnings, unless the global economy picks up,” says Peter Cardillo, chief market economist at First Standard Financial.
It’s going to be harder and harder to produce solid earnings, unless the global economy picks up.— Peter Cardillo, chief market economist, First Standard Financial

Most worrisome is that China is slowing dramatically, though no one is sure how much because the data is so unreliable. The official statistics put the rate at nearly 7 percent, a third slower than five years ago. But experts tracking electricity usage and other measures say the rate may be much worse, perhaps 4 percent or even lower.
“Mystery meat,” is how famed bond investor Bill Gross characterized China on CNBC on Thursday after the country’s main stock index plunged seven percent.
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China matters because it is the world’s second largest economy after the United States. It accounts for just a fraction of U.S. exports, but it’s impact on the economy is big because it is a major buyer of goods from Japan, Europe, and other big U.S. trading partners. About half the sales in the S&P 500 come from abroad.
James A. Abate, chief investment officer at Centre Asset Management, is impressed with how the biggest U.S. companies restructured their operations in the face of slow economic growth in the past few years. But when it comes to increasing profits, even he thinks they have run out of tricks.
“The vast majority of companies depend on an accelerating economy,” he says. “The downside to profits still has a long way to run.”

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The stock market bubble was supposed to herald a new Chinese version of the American dream. 
Rising share prices leading to a prosperous consumer class. Alas, it ended with tears and a 40 percent crash in July. 
Since then, the daily newsflow has abated and prices have recovered almost 30 percent from the lows. 
But the effects of the Chinese stock market bubble and its burst may be longer lasting, despite a relatively small effect on the Chinese economy.
“It was intended to rebalance the financial system from its excessive reliance of bank loans and create a dynamic stock market to finance future growth,” writes Satyajit Das, author of  “Traders, Guns & Money” in an analysis for Nouriel Roubini’s EconoMonitor. 
Instead, it created even more debt in the system through margins loans backed by stocks, which have now gone down in price, wiping out about $3 trillion to $4 trillion of market capitalization in the process.
“The amount of official margin debt extended by securities companies of $250 billion – $300 billion may only be a fraction of the real level of stock secured debt. Once vehicles like umbrella trusts, private lending arrangements etc. are included the amount may be 50-100 percent higher,” writes Das.

But companies only raised around $100 billion in initial and secondary offerings to pay back unsustainable debt.
So net/net, this operation destroyed value, rather than create it, like so many centrally planned operations in China.
“The banks were lending money directly or indirectly to investors to buy shares where the proceeds may have been used to pay back the bank. In reality, the banks had just exchanged risks without necessarily reducing the risk of loss. The circularity has been compounded further after the share market falls,” writes Das.
He thinks the stock market episode was just another example of Chinese policy makers trying to direct their citizens’ savings to achieve their goals. 
“The regime relies on keeping the cost of funds artificially low usually below inflation rates. The system allows Communist Party connected firms and privileged insiders to benefit,” Das writes.
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After the crash, both sides lose. Many of the lower to middle income investors have lost their savings in the stock market crash. The financial and government elite cannot tap their funds anymore and faces social discontent.
The central planners wanted to have their cake and eat it too, but at the end they are left empty handed. 

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