Welcome 2016 a new year that thus far seems synonymous with “volatility” as all major global equity markets have opened the year with big downward swings. Oil, Equities, Fed Policy, Iran, Saudi Arabia and North Korea dominate the headlines daily. China’s stock market is a scary place right now, with the Shanghai Composite dropping over 14% from January 4th thru 7th, activating a new circuit-breaker rule that stopped the trading session each day.1 The S&P Nasdaq and German Dax were each down more than sharply after the first full week of stock trading. 1,2,3
What’s causing the nosedive in China’s stock? You can cite several reasons. You have the well-noted slowdown of the country’s manufacturing sector, its rocky credit markets, and the instability in its exchange rate. You have Chinese concerns about the slide in oil prices, heightened at the beginning of January by the erosion of diplomatic ties between Iran and Saudi Arabia. You have China’s neighbor, North Korea, proclaiming that its arsenal now includes the hydrogen bomb. Finally, you have a wave of small investors caught up in margin trading and playing the market “like visitors to the dog track,” as reporter Evan Osnos wrote in the New Yorker. More than 38 million new retail brokerage accounts opened in China in a three-month period in 2015, shortly after the Communist Party spurred households to invest in stocks. Less than 10 million new brokerage accounts had opened in China in all of 2014.1,4
Remember that all of these new investors in the market have little if any prior investment experience. Just like retail investors here or in Europe are more likely to sell quickly and buy late which is the exact opposite behavior on experienced investors. In China, North Korea, and most of the emerging Asian markets retail investors considerably outnumbered experienced and institutional investors (often called the smart money), so volatility is basically a given.
Oh and the trading circuit breakers introduced on Monday January 4th by the Chinese government have been a major contributor to their market decline. My colleagues at Preston Wealth Advisors shared the following with me last week:
The Chinese markets were already known for their volatility, so the introduction of circuit breakers seemed to make sense. The problem is, they set them too low. If the Chinese market falls 5%, trading is halted for 15 minutes. If it falls another 2%, trading is halted for the rest of the day. Contrast this to the US markets.
The US “circuit breakers” are as follows:
If the DJIA falls 10% trading is halted for 60 minutes
If the DJIA falls 20% trading is halted for 120 minutes
If the DJIA falls 30% trading is halted for the day.
Because the Chinese have set the curbs so low, this has actually increased volatility as traders rush the doors to beat the curbs. Chinese officials are beginning to recognize their mistake and are already taking steps to help reduce volatility.
Let’s not forget that last July, Beijing barred all shareholders owning 5% or more of a company from selling their stock for six months. That ban was set to expire on January 8 and that deadline stirred up bearish sentiment in the market this week. The prohibition was just renewed, with modifications, for three more months.
Yet, something else could be the real “big “problem in China. Over the past few decades’ investors money from all around the world has gone into China and other emerging market economies fueling one of the great expansions in economic history. And not so quietly that flow of cash is not just subsiding but actually reversing course. The Institute of International Finance (a trade group representing international bankers) expects that when the final numbers are tallied last year will be the first net outflow of capital from emerging markets in 27 years. The group further expects another $500 billion worth of cash previously invested in things like Chinese factories, Brazilian government bonds, and Nigerian equities to flow out of those markets in 2016.
These are just forecasts, but there’s plenty of other evidence that’s consistent with this story. The flood of foreign currency into China the past few decades has resulted in a $4 trillion stack of reserves.
An example of evidence to support these forecasts that pile of reserves has been shrinking fast was the announcement last month that China had burned through more than $100 billion in reserves in December, as it tried to keep the currency propped up in the face of large-scale selling by investors. China’s effort to keep its currency from collapsing is part of the central government’s commitment to manage a slowdown of the world’s second-largest economy and keep it from turning into a panicky recession full of unforeseen risks.
Alternately, China could let the currency weaken further; saving some of its reserves, but allowing the currency to decline could also make the market situation worse, thus driving nervous investors to sell Chinese assets even faster in order to avoid further currency depreciation. Sales of stocks (outflows) by foreign as well as panicky homegrown investors can cause big spikes and declines for Chinese stocks even for companies with good fundamentals.
To say stay tuned is more than an understatement, yet discipline in moments such as this is paramount to turning ‘turmoil” into opportunity.
1 – cbsnews.com/news/7-reasons-the-dow-lost-17000/ [1/7/16]
2 – qz.com/588386/chinas-new-stock-market-circuit-breaker-is-broken-and-it-is-panicking-investors/ [1/7/16]
3 – usatoday.com/story/money/markets/2016/01/06/china-stocks/78390650/ [1/7/16]
4 – latimes.com/business/hiltzik/la-fi-mh-a-reminder-china-s-stock-market-is-a-clown-show-20160107-column.html# [1/7/16]