Don’t ignore these two warning shots – markets are on thin ice

published 19 January 2015

150119-china-stocks — Chinese markets got hammered as regulators banned investors betting big with borrowed money

The world's governments may be trying to tell investors something.

Last week, markets got a nasty reminder of what can happen when a source of cheap money is pulled out of the market.

The Swiss central bank's decision to stop keeping the franc artificially weak against the euro stunned investors. It even drove some to the wall.

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This morning, investors got another sharp shock this time from China.

Chinese regulators banned the country's three biggest brokers from opening new margin accounts (which allow small investors to bet big on markets using borrowed money) for three months.

The market, which rose 53% last year, plunged by 6% this morning, the biggest one-session fall in six years.

What's the message? Don't take anything for granted.

The Chinese regulator slams the stockmarket

Small investors are treating it like a one-way bet. When people think something is a one-way bet, they get careless. They don't think about the downside. That's particularly problematic when they're using borrowed money.

For a prime example, you just need to look at what happened last week. Lots of investors came a cropper when the Swiss central bank suddenly whipped the rug out from under them. One big broker in the UK, Alpari, even went bust.

Everyone had assumed that the Swiss National Bank's floor' value of 1.20 francs to the euro would be held, and that the bank would give fair warning of any change of plan. It didn't. And complacent investors paid the price.

In China, reports the FT, investors were getting similarly unwary. In the 11 months to November 2014, an average of 232,000 margin-trading accounts were opened each month. In December, that rocketed to 724,000.

In other words, Joe Bloggs in Shanghai was whipping his life savings out of the property market and punting them all on Chinese stocks instead, with a good chunk of borrowed money on top.

Naturally, the market got hammered.

There's a lot more complacency out there

But it's also reassuring to see the regulator paying at least some attention to moving it from being a step up from a Macau casino, towards acting as a mature, fully-functioning capital market.

What's more interesting is to look at these moves as useful reminders of the wider environment we're all investing in right now. Because it's not as if investors have only been betting on the largesse of the Swiss central bank and the Chinese regulators.

Quantitative easing (QE) has helped to underwrite asset prices across the globe. As Axel Merk notes in the FT this morning, "central banks the world over have made risky assets appear relatively safe in plain English, complacency is rampant."

Just as investors were too relaxed about the Swiss central bank, they may be far too calm about the valuations of "stocks and bonds worldwide," warns Merk.

The US isn't doing QE any more. Neither is the UK. Japan is doing a staggering amount, and you can't rule out the idea that they might do more. But really, it's all riding on the European Central Bank's (ECB) next move this Thursday.

My view for what it's worth is that ECB boss Mario Draghi will rise to the occasion, and he'll do his best to convince the market that he's serious about QE. That would keep the show on the road for a while longer.

But I'm also aware that it increasingly looks as though the market is starting to price that view in. Just look at the plunge the euro took on Friday afternoon. Draghi is really going to have to generate some financial shock and awe' if he's to beat expectations.

So it's always sensible to hedge yourself against disappointment. We've always advocated hanging on to some gold in your portfolio as insurance against financial panics. If investors start to worry that central bankers are no longer on their side, we suspect that insurance will pay off handsomely.

You can learn more about gold and how to buy it in our complete guide to your finances for 2015 and get your first eightissues of MoneyWeek free by subscribing now.

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.