Hot Alibaba float and easy money signs of a big correction coming

It is always hard to pin a stock market correction on a single event, but when investors look back at what’s happened over the past few weeks as the stock market has dropped by 5 per cent (half way to an official correction) they will focus on the float of a single company, the giant Chinese trading house, Alibaba.

Ranked as the second-biggest initial public offering ever, the $US21.8 billion in fresh capital raised by Alibaba puts it just behind the $US22 billion raised by the Agricultural Bank of China in 2010 – a gap which says much about the care taken by Alibaba management not to outdo a government organisation.

Niceties aside, there is so much not known about Alibaba, such as exactly who’s who in the management team, and why outside investors do not own some of the key operating assets, that it’s fair to say there is a touch of the “black box” to the business, which seems to be all things to all people.

Described as a Chinese equivalent of Amazon, eBay and PayPal rolled into one, Alibaba does almost all of its business inside China, a place that can be very friendly to the locals and very unfriendly to foreigners.

It is the unknowns about Alibaba that have some seasoned stock market observers wondering whether they have just seen a case of global herd behaviour, with seemingly smart people reacting to reports which praise the virtues of exposure to the shopping habits of China’s fast-growing middle class without really knowing what they’re buying.

A key to understanding the Alibaba effect, which has overnight created a business valued at $US220 billion, is that investors around the world have been starved of reasonable returns in their portfolios for so long that they are happy to buy anything that has the potential to boost earnings.

Ultra-low interest rates are the root cause of the Alibaba effect, plus a willingness of banks to start lending the vast amounts of cash sent their way by governments keen to kick-start growth in the wake of the 2008 global financial crisis.

The cocktail of cheap money, a hunt for yield on investments, a boom in US technology floats, and a rush by big companies to buy back their own shares using low-cost debt as a replacement for capital has sown the seeds of a correction which could become something more significant.

The problem for everyone with investment exposure is that so much of what’s happening today can be described as either artificial, or transient, or both.

Stock markets around the world are not being driven by the traditional forces of profits and dividends, they are being driven by share buy-backs and capital returns, which is nothing more than a form of corporate self-cannibalism.

In effect, the directors of many companies have run out of ideas as to how they might grow their business, reckoning that the best investment (and the one which will please shareholders) is to buy their own shares, effectively shrinking the business and, as everyone knows, you cannot shrink your way to greatness.

Alongside the buy-back phenomenon, there is a remarkable rise in loans from banks for either share trading or investment in residential property.

According to one study of the loans being made by US banks, the level of leveraged loans for investment purposes is now just short of the ratio reached just before the GFC.

Junk bonds, or so-called high-yield loans made to the weakest borrowers, are also on the rise as banks rush to get the cash in their accounts into the market earning some sort of return rather than suffer the near-zero rates available from buying government debt.

Big floats such as that of Alibaba are another telltale of a market close to its peak.

No-one knows when, or even if, a major correction will wash through the global financial system but there are so many warning signs flashing red that it would be foolish to ignore the evidence, which points to something significant happening sooner rather than later.

A turning point in the current situation will be the day the US raises interest rates for the first time in years, an event expected to occur in the next six to nine months.

Markets, interestingly, tend to react well before a big event, which possibly points to what might be another “October surprise” of the sort that gave the world the 1987 crash, or the 2007 collapse of Lehman Brothers.

Whatever happens, and whenever it happens, we are getting close to a period of significant change as interest rates start their slow climb to more normal settings.

Hang on tight for what could be an interesting ride.