Jeff Miller

About the Author Jeff Miller

Jeff is the President of NewArc Investments Inc., manager of both individual and institutional investments. Jeff is a registered investment advisor, and portfolio manager for NewArc's investment programs. Jeff is a former college professor with a hands-on, real world attitude. His quantitative modeling helped inform state and local officials in Wisconsin for more than a decade. A Public Policy analyst, he taught advanced research methods at the University of Wisconsin, and analyzed many issues related to state tax policy. Jeff began in the financial business as Research Director for trading firm at the Chicago Board Options Exchange. He investigated anomalies in the standard option pricing models, taught classes for beginning options traders, and developed new forecasting techniques. In 1991 he established a general research consultancy, working with professional traders at all of the Chicago financial exchanges. In 1998 he started NewArc Investments, Inc. Jeff has a commitment to the specific needs of individual investors. NewArc offers five different programs. It is not a one-size-fits all approach, but one that emphasizes the unique circumstances of each client. Jeff also serves on the board of two small technology companies (currently Chairman at one). He is occasionally as an expert witness in legal cases involving financial markets and hedging.

China Crisis and Your Portfolio: Analysis

News about the Chinese stock market has dominated the first week of 2016 trading.  Headlines scream and experts explain.  (The China experts look amazingly like the same people who were experts on Greece last year, but maybe my vision is going bad).

How much of what we hear is accurate?  What is the best approach for traders and for investors?

Facts, Fears, and Rumors

The first step in analysis is to find a fact-based foundation.  Next we need to understand the implications. And we must do this without emotion.

The Facts

  • Chinese stocks have been hard-hit each day this week.
  • Many attribute this to front-running regulations which limit sales starting tomorrow.
  • Some also note today’s currency devaluation of about 2% versus the dollar.
  • Official efforts to support the markets have failed, with circuit breakers kicking in almost immediately.  (MarketWatch)
  • Without true price discovery, no one knows for sure how low the Chinese market might go.

The Rumors

  • China intends a further currency devaluation of as much as 10%.
  • Chinese economic growth is much lower than the official data shows.
  • China may end the circuit breaker program.

The Fears

  • Emerging market countries will lose their largest customer.
  • Lack of Chinese demand has undercut oil prices.
  • China, the second largest economy, may well drag the entire world into recession.
  • Stock markets are already at a dangerous tipping point, and China could be the trigger for a major decline.

Analysis

Many of the fears about China reflect a two-variable, linear thought process.  It is something we have seen before, most notably last August, so both humans and computers are programmed to react again.

For China to have an important effect on the world economy or recession odds would require the following to be true:

Events and Comments

The basic idea (from two years ago, but accurate in the approach) was nicely stated in the IMF Forum:

Mongolia’s economy grew nearly 12 percent last year, the United States around 2 percent. So Mongolia grew around 6 times faster than the United States, yet of course the United States contributed more to GDP growth—over 150 times more. Why, because size matters.

Let’s apply this logic to China. A bigger but somewhat slower growing China of the future will contribute about as much to global demand as the smaller but faster growing China of before. This is arithmetic: An economy that is twice as big can grow by ½ as much and contribute the same to global demand. By the way, China today is more than twice as big as it was a decade ago.

This analysis from Econbrowser provides a helpful supporting chart.  Notice the constant contribution from China (red bar) despite the changing growth rate.

china_jul15_5

What to do?

As so often happens, the answer is different for investors and traders. Last year I recommended stocks that did not have a strong China link.  That does not work at the moment, since the market perception is not limited by borders.

The expansion of the China effect into a wide range of good companies — biotech, home builders, banks, U.S. consumption — provides an opportunity to buy at prices you did not expect to see.  While ignoring China is the right thing for investors to do, few can act.  Fighting fear and market declines is easier to say than to do.

For traders, things are trickier.  Eventually the fundamentals will prove out, but it is crazy to fight the market fixation.  At the moment, it is all the market cares about.  One of my favorite trader friends always said that he did not want to know anything about the fundamentals.  He could trade successfully without even knowing what he was trading!

Traders will eventually (maybe soon) get an end to the apparent China free fall.  Those who are most agile and guess well have an opportunity.

iShares FTSE/Xinhua China 25 Index (ETF) (NYSEARCA:FXI), a cap-weighted index of the 25 largest Chinese companies, closed yesterday at $31.97, down $1.25 or -3.76%.