The market decline: how linear thinking about China missed geopolitical warning signs.
This past week exemplified why geopolitical considerations should be taken into account for timing market purchases or sells. Yet market analysts from CNBC, Bloomberg, and a host of other online and traditional media outlets generally ignore them in market-timing recommendations. Moreover, they not only ignore them, but often denigrate their importance. It cost investors 2 trillion dollars over just the past two days.
For a few months now, a possible Grexit (Greek exit from the E.U.) and the Chinese markets have afforded headlines to explain wide fluctuations in market moves. Even the most casual observer knows this. Yet analysts have taken pains to reassure investors that 1) the Greek economy is tiny and therefore it doesn’t matter whether there is a Grexit or not, and 2) only a small portion of most American businesses is dependent on sales to China and so investors shouldn’t worry about the crash and then false propping up and then subsequent crash of the Shanghai market. How can these analysts be so blind?
One explanation can be found in the incessant need to keep buyers coming into the market. A corollary goal is to keep those buyers that are in the market from selling out and leaving it. The market industry is based in large part on meeting those two objectives. Bear markets, apart from the most volatile days, are generally accompanied by much lower volume–and that means smaller and fewer commissions for brokers, less need for surplus analysts, market-making traders, etc. Ask any broker you know well enough to tell you the truth, how he or she did during the bear market that began in ’08. It was caused in large part by the liquidity meltdown of banks and other institutions that were market gamblers, securities, mortgages of questionable equity protection, and repurchase agreements. These were well beyond the more conservative, and safer, role of primarily being just solid repositories of government guaranteed citizen’s deposits. Part of the problem was a political one: a Republican administration that was ideologically committed to reduce regulatory interference with the free enterprise system–and thus were lax on enforcing regulations already on the books. If you doubt all of this, consider the former world’s largest bank, Bank of America, who in short order (to participate in the investment gravy train), bought out Merrill Lynch and the liberal mortgage lender Countrywide. Just look at how close many such banks came to going under–and probably would have without government intervention–as well as the billions and billions of dollars in fines that they have since paid. There are many, many, more examples and we need only look at the sudden dissolution of investment banking giants like Bear Stearns and Lehman Bros., to be reminded of the need for vigilant enforcement of such an important industry’s regulatory obligations. Have we learned a lesson from the worst market crash since the Great Depression that followed the market crash of ’29–which, not coincidentally, also occurred during an anti-regulatory Republican administration? Apparently not. The Republican party, once again, is in control of both houses of Congress and is pledged to repeal the Dodd-Frank Wall Street Reform and Consumer Protection Act, whose regulations on banks investments was enacted following this last Great Depression.
Another explanation comes from the linear thinking of the vast majority of market analysts. An example from the past two months comes to mind. Apple Computer, the giant cell phone and computer company. Going into the past quarterly reporting period in July, the stock had risen to 133 on expectations of sizable growth in China. When Apple reported results less than analyst’s expectations, the stock dropped about 8 points to 125. Over and over I heard and saw recommendations to buy Apple since the earnings were up. After all shouldn’t you buy on dips? This kind of zero-sum thinking missed the possibility that the trading range that Apple and other market leaders with exposure to China might move lower. It ignored the likely effect that reduced growth in China, due to their earlier market meltdown would likely have on expectations of Apple’s China growth. Since expectations lead to higher or lower earnings multiples, this was potentially a negative effect. In the meantime, China’s attempt to support their market started to unravel. During this period of uncertainty, Apple’s stock moved into a new, lower trading range. The decline had broken its 200 day moving average, another big technical negative. Now its new trading range was 110-119, the then 200 day moving average, which had turned from being a technical support level to a supply level. Again, the linear thinking analysts said buy on this new dip, and it had a one-day rally right up to that supply level. These analysts vastly underestimated the worldwide effect of a China slowdown on the world economies. Many of which have economies that have big agricultural and mineral components whose prices were significantly affected by the Chinese slowdown. We export American goods to these countries, so we aren’t immune from their angst.
Unsurprisingly the Shanghai market started going back down once the artificial props that China was inserting into it ended or slowed down. It is important to note that the recent Shanghai decline accompanied the geopolitical event of the IMF refusing to include the Chinese Yuan as a reserve currency. It was still too artificially propped up. We’ll consider it next year, they said. Guess what would happen in terms of governmental devaluation of the Yuan, closer to a fair market level. And, what effect do you think that would have on China’s artificial propping up of the Shanghai market? Did you guess devaluing the Yuan and removing the market props? If so, what effect did you think this would have on the way overpriced Shanghai market? Bingo–a crash. And how easy do you think it will now be to raise foreign capital for economic expansion? Ignorant means ignoring available facts. The ignorant linear-thinking analysts must have started to wonder if they failed to consider some available facts. In the world’s markets, concerns started expanding as the possibility of a wider effect on their economies by a China slowdown started affecting most market expectations, and hence stock prices. Most of the other Asian markets started to slump alongside the declines in the Shanghai market. The European markets which had rallied on another geopolitical event, predicted here in this blog–the apparent resolution of the Greek crisis–started to dump as the focus finally shifted to China. How many investors got sucked in to buy on that first dip by the failure of those linear-thinking market analysts to understand that changes in the Chinese economy involve way more than the small percentage of most American companies’ sales that they were considering. Back to our market example, Apple’s stock went all the way down to 92 as part of an attempt to define a new trading range of roughly 93-110. That’s a long way down from the roughly 133 that Apple was trading at leading up to their reported earnings that missed expectations, back in late July. A friend of mine asked me about buying Apple on the dip to 125. When I said even if you want to buy it now, hold on a bit and you’ll get it for at least 110, he assured me that it didn’t matter since he was in the stock for the long-run. Good. But it will take a move now of around 30% just to get back to where it was on the “dip” to 125! The theoretical advantages of long-run investing have been proven. But there is nothing in that theory that precludes considering geopolitical factors in determining market entry points. Above all, be careful when there are danger signals from geopolitical conditions that are being understated or ignored by linear thinking analysts. This is especially true in over-bought volatile markets, easily determined by measures of volatility like changes in put-call ratios and very low VIX index numbers–a VIX number under 13 suggests an over-bought market. Which is exactly what happened at the beginning of this current crash–or if you prefer, correction.