The China Bear Market

The U.S. stock market has been pretty… um, volatile lately. In fact, I’d say it was downright scary on a couple days in August. But make no mistake: The 12% correction we saw had very little to do with the Fed and whether we’re about to get an interest rate hike.

No, this sell-off was all about China.

Now, I don’t mean to say that I am simply ignoring the Fed. Rate hikes absolutely are a market-moving event.

When you charge more for money, it reduces the velocity of money. And right now, with U.S. economic growth still running at a tepid 2.5%, money is not exactly flying around courtesy of loans and investment. For the most part, money is still just sitting there…

The fact that corporations would rather buy back their own stock than invest in expanding production is telling. And it’s especially attractive for corporations to borrow against their cash to fund buybacks because rates are so low.

Stock buybacks can make companies look more attractive than they actually are. Because when you lower the number of shares outstanding, it raises that company’s earnings per share. The price-to-earnings ratios look better. It looks like earnings are growing, but they aren’t. In fact many companies today are seeing flat revenue and rising earnings.

In some cases, revenue is actually falling. But earnings are rising because of share buybacks.

This is what people mean when they say that Fed’s zero interest rate policy is creating distortions in the market. And it’s true — by leaving rates at zero for so long and buying $4 trillion in bonds to force rates down, the Fed has created distortions in the stock market.

I don’t think any of us believes the S&P 500 would have made it to 2,134 without zero interest rates and QE. But it should take more than a couple quarter-point rate hikes to have an impact on the real economy and corporate earnings. For that, you gotta look to China…

The Biggest Threat

It’s been a while since we’ve seen a 10% correction for U.S. stocks. But I’m sure you remember the European debt crisis, when Spain, Italy, and Greece needed massive bailouts to keep their banks from going under.

Then there was the fiscal cliff that threatened to shut the government down.

And who can forget that time Standard & Poor’s lowered its rating on U.S. debt?

Each of these sounds scary, and they each led to some scary sell-offs. But the worst potential catalyst we saw in the last few years was Ebola.

You wanna see global economic activity grind to a halt? Just unleash a deadly virus on the world. People will stop traveling immediately, ships will stop coming into ports, and people may even stop going to work.

We were fortunate that the spread of Ebola was stopped as quickly as it was, because Ebola definitely had the potential to push the whole world into recession.

I don’t mean to minimize the human cost of Ebola by comparing it to the Chinese economy. But the fact remains that China has the potential to push the global economy into recession.

And as it happens, some parts of the world are falling into recession right now…

Recession Bells

South Korea is an export economy. Half of its GDP comes from selling stuff to other countries. It’s also the world’s biggest exporter to China. So you’d expect that when China sneezes, South Korea gets the flu.

South Korea’s exports to China have been falling for eight straight months. In August, total exports were down 15% from last year. Exports to China were down nearly 9%. Those are huge declines, and they clearly show that China’s economy is slowing. Demand is getting weaker.

Now, South Korea exports finished and intermediary goods. The situation is worse for commodity exporters. Canada is already in recession, and Australia is expected to put up 0.7% GDP growth this year.

But still, China’s economic slowdown has been made worse by the government’s response. When the Chinese stock market bubble popped in early summer, the Chinese government made some drastic moves, closing many stocks for trading, banning short selling, and making it illegal for corporate insiders to sell.

The government also started buying stock to help the market.

Then, as we know, China devalued the yuan on two separate occasions, hoping to boost its own export economy by making Chinese goods cheaper.

Now, there is no doubt that China’s transition from an agrarian economy to a city-based consumer economy is a herculean task. Despite the inevitable speed bumps we should expect, Western investors have consistently given China’s leaders the benefit of the doubt. We assume they have a plan and can respond to whatever challenges the Chinese economy might face.

But so far, China has been unable to get growth turned around. And the latest moves look amateurish and even desperate.

At the recent World Economic Forum, Chinese Premier Li Keqiang said: “The [Chinese] government took measures to stabilize the market and prevent risks from spreading, we have forced out the possibility of any systemic risks.”

Really? You’ve forced out the possibility of systemic risks?

I know that statement was supposed to instill confidence, but it does exactly the opposite for me. I don’t believe you can simply force out risk. To believe you can smacks of hubris.

I can’t tell you there is an imminent crisis brewing in China. But I can tell you that confidence in China’s ability to manage a crisis has weakened.

Every day the Chinese economy stays out of the news, U.S. investors bid stocks higher. We’re not worried about the Fed — it’s China that has the potential to make a real bear market.

Until next time,

Until next time,

Briton Ryle

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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.