Why China Evergrande’s Debt Problem Won’t Take Down The Market

The China Evergrande debt problem was a convenient catalyst for global stock markets. However, I decided to invest ~$200,000 in the S&P 500 because I don't believe there will be material contagion. The money came from a recently exited 5-year equity structured note.  

China Evergrande was founded in 1996 and sells apartments to mostly upper and middle-income dwellers. The company's market cap peaked at around $50 billion in October 2017 and is now currently at about $4 billion. 

China Evergrande Is A Small Company

A $4 billion market cap is tiny in the relative scheme of things. In comparison, Toll Brothers, a U.S. homebuilder has a $7.2 billion market cap. The U.S. economy isn't going under if Toll Brother collapses. Instead, its competitors would likely buy up the company's assets in a fire sale.  

Further, we've had five years of watching China Evergrande decline. Investors didn't just suddenly realize the company had a massive and potentially unsustainable amount of debt.  

The Chinese government can easily bail out China Evergrande, especially since thousands of private citizens will end up losing lots of money on their deposits or purchases if they don't.  

Therefore, I believe the government will, but in a fashion that will minimize moral hazard for other highly-indebted companies.

China Evergrande's debt problem and historical stock chart

Related: To Understand Capitalism, We Must First Understand Communist China

Buy The Dips If China Evergrande Causes More Problems

If there is another sell-off due to the China Evergrande debacle, I will be buying more equities. Comparing China Evergrande to Lehman Brother's collapse in 2008 is far fetched. 

In February 2007, Lehman Brother's had a market capitalization of $60 billion. That year, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an $85 billion portfolio, or four times its shareholders' equity. Lehman's tentacles were all up in the U.S. economy. 

The Global Financial Crisis was a real debt debacle. It wasn't just one company taking on too much debt. It was an entire nation of greedy homebuyers leverage too much. Of course, it was an industry of greedy bankers who also lent more than they should.

Another reason why I plan to buy any upcoming dips is due to  the Federal Reserve's clear messaging. The Federal Reserve said on September 22, 2021, it will likely begin reducing its monthly bond purchases as soon as November 2021. It also signaled interest rate increases may follow more quickly than expected as the U.S. central bank's turn from pandemic crisis policies gains momentum.

The first signs of tapering is often a negative sign for the markets. However, the day the Federal Reserved made its announcement, the bond market barely moved. This indicates expectations for tapering is 100% baked in. 

In other words, the market is looking beyond tapering to better days ahead. If brighter days weren't expected by the Fed, they wouldn't be tapering. In the long run, everything is rational in finance.

A Good Reminder To Control Your Debt

The China Evergrande debt debacle is a good reminder to control your debt.

Massive debt is fueled mainly by massive greed. In a bull market, it's easier to take on debt to try and make greater returns. However, eventually, asset inflation will slow and sometimes your sources of income will dry up. 

​​​​​​​Therefore, please manage your Asset-to-Liability ratio. The greater the ratio, usually the better. 

Target asset-to-liability ratio to control your debt and grow your wealth responsibly

To retire comfortably, I think the ideal steady-state asset-to-liability ratio is 5:1 or greater for the majority of people. In other words, have at least $5 worth of assets for every $1 worth of debt. 

With at least five times more in assets, you’re in a fiscally sound position to weather almost all economic downturns. Further, with “good liabilities” like mortgage debt equal to 20% of your assets or less, you have enough leverage to give your net worth a boost during good times. 

Once you're in your 60s or older, getting to an asset-to-liability ratio of 10:1 or higher is ideal. Eventually, I believe everyone should retire debt free. 

After buying a new property in 2020, my asset-to-liability ratio fell from around 15:1 to 9:1. Over the next couple years, I plan to get my asset-to-liability ratio back above 10:1.

Leverage Debt Wisely For Greater Wealth

The best type of debt is mortgage debt. The reason why mortgage debt is the best is because it is tied to a historically appreciating asset. If you can take on debt at a low enough cost while the asset appreciates at a faster rate, you win in the long run.

Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.

Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing.

CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends.

I've personally invested $810,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$300,000. 

When investing in private real estate deals, make sure you are comfortable with how the capital stack is structured. Too little equity or too much debt is no good.