Yesterday morning we discussed the sudden crashes amid 17 small cap Hong Kong firms, which collectively lost over $6 billion in market cap, on what we dubbed was a marketwide margin call, as confidence in the entire sector vaporized instantly, sending the small cap Growth Enterprise Market (GEM) plunging by over 9%, with some stocks plunging over 90%. Quoted by Bloomberg, Francis Lun, the CEO of HK's Geo Securities said “we’re seeing a domino effect; all the companies in the same network got cut. These shares are owned by the same group of people so they must be experiencing a liquidity crunch and they don’t have the money to support the share prices."
It turns out there was more to this story, at the heart of which is a report issued six weeks ago titled “The Enigma Network: 50 stocks not to own” by David Webb, a former director of the Hong Kong stock exchange, whose argument is that companies which crashed were entwined in a complex web of cross-shareholdings that had pushed their valuations to unsustainable levels. As Reuters adds, "Webb's report mapped out a complex web of cross-shareholdings between companies listed on both the main board and its sibling, the Growth Enterprise Market, which he said created a breeding ground for volatility."
In other words, Webb mapped out the margin call domino effect whose impact was not a question of if but when. It is shown in the chart below.
David Webb’s graphic representation of ‘The Enigma Network.’
And, as Bloomberg notes, if investors ignored him until now, they’re paying the price, and not just on Tuesday when the first hit stuck, but also on Wednesday, when the selloff in the GEM continued with many stocks dropping a further 20-30%, and this time starting to impact the broader Hang Seng index.
HK Penny Stocks that evaporate billions of HKD yesterday continue to plunge today, -15%~30%... Dragging down the entire HK stock market now.
— Simon Ting (@simonting) June 28, 2017
The turmoil once underscored how the Hong Kong Stock Exchange and its sibling, the Growth Enterprise Market, have become a breeding ground of wild volatility according to Bloomberg, a phenomenon which has raised red flags for the city’s regulators, who have warned small-caps can be black boxes and, at times, subject to manipulation.
David Webb
Webb, who is an activist investor who’s been a vocal critic of the Hong Kong exchange since he quit the board in 2008, has been calling on authorities to do more to protect investors. “What this really points to is the ongoing problems with our legal and regulatory system for listed companies,” he told Bloomberg in an interview on Tuesday.
While the Hong Kong’s Securities and Futures Commission said it couldn’t comment on whether it’s pursuing any investigations, the regulator did note note that Tuesday’s biggest decliners tended to have characteristics conducive to extreme volatility and market misconduct: multiple relationships between different companies and listed brokerage firms, high shareholding concentrations, low volume and small public floats. Oh, and questionable underlying collateral value, which due to cross-asset holdings, means that a selloff in one company would promptly hit the entire sector.
That's precisely what heppened on Tuesday and again on Wednesday, when the selloff continued and the GEM market fell to a new record low as a swathe of small-cap stocks continue to tumble in the wake of Tuesday’s $6bn drop. On Wednesady, the S&P/HKEX Growth Enterprise Market index fell as much as 2.3% to 279.17 on Wednesday, the lowest intraday level on record for the index and down 11.8% in the week to date.
According to the FT, among the worst-hit GEM stocks on Wednesday was GreaterChina Professional Services, down another 39.1% on Wednesday, while fellow GEMs WLS Holdings and Hao Wen Holdings had dropped 56.3% and 48.7% , respectively.
As noted previously, Hong Kong Exchanges & Clearing Ltd., which proposed sweeping changes to its small-cap market earlier this month to revive confidence in the venue, said it couldn’t explain Tuesday’s moves. It was unable to add more color on Wednesday either.
Demonstrating once again just how incapable of fundamental analysis the market has become, while the stocks highlighted by Webb barely budged when he released his report in May, they accounted for all but three of Tuesday’s 20 biggest losers in Hong Kong.
In total, 38 of the 50 stocks flagged by Webb fell on Wednesday. By the close, the S&P/HKEX GEM Index dropped another 0.8%, following Tuesday’s 9.6% rout.
Ultimately, as Bloomberg notes, "whatever the catalyst for the selloff, investors can’t say they weren’t warned. As Webb flagged six weeks ago and reiterated on Tuesday: “A lot of the stocks were very overvalued.”
Ironically, the market is now ignoring similar warnings by none other than Yellen, Fischer and Dudley. We wonder how long until a similar "post-mortem" phrasing will be applied to the broader S&P market, when "nobody could have possibly foreseen the coming crash."