Risk is Rising

For years, the investment thesis on China has basically been a numbers game.

If Ford can just get 5% market share, it would boost revenue by billions… or if Starbucks can execute its China expansion plan, profits can jump 50% in two years…

This type of basic analysis sounds pretty good. Even though they are not wealthy as a whole, 1.3 billion people represents a lot of spending power. No multinational company can afford to leave China out of its growth plans.

But that doesn’t mean there aren’t significant challenges for any company that wants to do business in China… even Chinese companies.

And so you know, this article isn’t about corruption or unfair business practices. Of course corruption and unfair business practices are big challenges to doing business in China. But they aren’t the only challenges.

Some of those challenges have been exposed over the last six weeks as China’s stock market crashed. And the implications go far beyond the price of Chinese stocks…

Growing Pains

There’s no need to recount the gruesome details of the Shanghai Index’s plunge. It’s fallen more than 30% since it peaked in late April.

If that happened to the Dow Industrials, we’d be looking at a 5,257-point drop from to 12,266. That would be an all-out panic, mass hysteria, dogs and cats living together…

American stocks have held up pretty darn well as the world’s second-biggest economy’s stock market crashes. You know global stocks wouldn’t be so sanguine if it were the Dow Industrials that was collapsing.

But then that’s one of the benefits (if you can call it that) of China’s mostly closed economy: It’s basically only Chinese that own Chinese stocks on the Shanghai Index. The direct fallout for the rest of the world from China should be minimal. It’s the indirect fallout we need to worry about.

China’s stock market crash will saddle Chinese investors with some pretty significant losses. There was an amazing story from CNBC yesterday about a farmer who lost it all during the crash after his broker convinced him to use 5X margin. Margin calls wiped him out. 

So now maybe Chinese consumers have to put off buying a new Ford or a new iPhone. Both Apple and Ford have a lot riding on the Chinese economy. Now add investment losses to an economy that’s already showing slowing growth. China’s Google got crushed by more than 10% yesterday. 

We’ve already seen what happens when companies rely too heavily on China in the commodity space. Production capacity for just about every commodity — steel, copper, cement, iron ore, oil, natural gas, etc. — expanded massively, in whole or in part to address Chinese demand. 

It didn’t take much of a slowdown in growth to push all commodities into bear markets. I don’t think it’s a huge stretch to imagine that the promise of Chinese consumerism for companies like Ford, Starbucks, and Apple may not be all it’s cracked up to be, either. 

You Can Fool All of the People…

Now, this doesn’t mean I will recommend that Wealth Advisory subscribers take the 155% gains we have in Starbucks. Starbucks is a great company, and it has more room to run in the months/years to come. My point is that as an investor, it’s critical to keep your BS detector in full working order at all times, or you could end up like that Chinese farmer.

You see, in that interview, he says he was enticed into the stock market by the Chinese government when it started to promote investing to the Chinese people. There’s nothing wrong with that in and of itself. A healthy stock market is important for an economy, and investing is an important way for people to grow their wealth over time.

However, when the government (or government officials) promotes investing, it can give off the illusion that there’s not much risk.

Former Fed Chief Alan Greenspan did this a couple times. In the late 1990s, Greenspan openly marveled at the massive productivity gains the U.S. made due to the Internet. He felt they could continue for years.

Investors took this to mean that it was different this time — that the very nature of the business cycle had evolved, that the U.S. could continue to grow, and that stocks would have no problem growing into their high valuations. 

Wrong. The business cycle hadn’t changed at all…

Greenspan did it again when he endorsed the way derivatives spread risk around the globe and said that lower mortgage standards helped more people achieve the American Dream of home ownership. 

Wrong again. Housing crashed, and derivatives helped spread the damage around the world. 

From tulip bulbs to the California Gold Rush to railroads to the Internet, investment trends follow the same pattern. Early opportunities entice more and more people, who take on more and more risk until it all blows up.

This is exactly what just happened in China — I mean, a broker who recommends using margin to leverage your assets by a factor of five? That is insane!

Insane is the End Game

That Chinese farmer travelled to Beijing to file his grievance with the Chinese government (apparently the government is the answer for everything there). They wouldn’t see him, but they are trying to stem the tide of selling.

I don’t know if there’s a Chinese phrase like “we’re from the government, and we’re here to help,” but China’s government has taken some extreme measures to support stock prices, including actually buying stock itself. 

Rumor has it that the Chinese government stopped buying shares on Monday to see if it had done enough to stabilize the stock market. It hadn’t — the Shanghai Index got creamed for 8.5%. So now the government is back to sinking more money into stocks. 

It’s pretty easy to kind of scoff at Chinese investors and think how naive they must be to trust that the government can make the stock market safe. 

But don’t lose sight of the fact that the same thing is happening here in the U.S., except it’s the Fed instead of the government. Investors just don’t see much risk right now because employment is improving and there seems to be upside for GDP growth. And besides that, the Fed has our back, right?

Only the Fed has already stopped the main thrust of QE (now it’s “only” reinvesting its $4.5 trillion in bonds as they mature), and it’s on the verge of hiking interest rates. 

For sure, risk is going to come back to investing. I don’t think that means a 30% crash like what China has seen. Because valuations got really ridiculous over there (the average trailing P/E is still around 60). Still, as the Fed steps away, risk is going to rise.

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.