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.
- 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.
- 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.
- 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.
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:
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.
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%.