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China breaking, Greece melting, Dow crashing

If you haven’t read MONEY DRAGON yet, you might want to.

The financial world seems to be rocking and rolling. It would be a good thing to use current events and personal finances to teach your kids about money. Hey – you might learn something, too.

About two weeks ago, China devalued its currency by 2%. Imagine that happening to you. Overnight, someone comes and takes 2% of all of your money; scary. But that is only the beginning.

China is breaking, Greece is melting, the Dow is crashing.

On Thursday, Aug 20, 2015, the Dow plunged 358 points. At that point, the Dow and the S&P 500 were negative for the year. That means if you had money in the stock market a year ago, and left it alone, you now have less money. The so-called “FANG” stocks – Facebook, Apple, Netflix, and Google – were some of the biggest losers.

Four days later, on Monday Aug 24, 2015, stock markets around the world plunged. Any profit you may have made in the stock market over the past year or so is probably gone.

The spiral began with an 8.5 percent drop in China's Shanghai Composite index. Coupled with the 2% devaluation of currency, that represents a loss of over 10% in a very short time.

Markets in Japan, South Korea, and Australia followed China’s drop. That sparked selloffs in European and U.S. markets. The Standard and Poor's index of 500 large US stocks fell by nearly 4 percent on Monday, adding to losses from the prior week. Things are sure to go up and down like a big rollercoaster; but not the fun kind.

There are some real reasons for investors to worry about the future of the global economy. Earlier this summer, we saw the entire nation of Greece melt down economically. It is still teetering on the verge of bankruptcy. Who repossess a country when it goes belly up? That is a question the EU has been dealing with for months, if not years.

China's economy is slowing down, which could produce not only economic hardship for its people but also political challenges for the Chinese government. With North Korea rattling its swords again, we don’t want a nervous Chinese government. Much of Europe is still struggling to emerge from the last economic downturn; more market turbulence is the last thing it needs. In the United States, six years of gains have produced prices that some experts believe are simply unsustainable.

The American stock market has been booming for six years. At present, however, the US stock market is down about 10 percent from its highs earlier this summer. That's a significant drop, but some think it looks less significant if one considers the larger picture.

What’s the larger picture?

The US stock market has experienced a huge boom over the past six years. Even after Monday's fall, the Standard and Poor's 500 index is 170 percent above the low point of the 2009 stock market crash, and 20 percent above the previous stock market peak in 2007.

Has the market gone too high?

One way to judge this is to compare companies' stock prices with their profits. This ratio, known as the price-to-earnings ratio (P/E ratio), is a pretty good indicator of whether the market is over or undervalued. Overvalued means there is a good chance it will go down. Right now, the P/E ratio is significantly higher than the historical average. That could be bad news.

At the start of 2015, the P/E ratio was around 26. That's almost as high as the peak of the 1929 stock market bubble (you have heard of the 1929 stock market crash, right?). A P/E ratio of 26 is higher than at any point between 1930 and 1990. If a high P/E ratio is an indicator that the market is overvalued, then this fact should make stockholders very nervous.

P/E ratios are affected by interest rates. When interest rates are low, people are willing to pay more for stocks in order to boost their returns. They ‘take their money out of banks and put it into stocks’. When interest rates are high, as in the late 1970s and early 1980s, stock prices tend to fall, since people can get high returns without taking the risk of owning volatile stocks.

So whether you believe stocks are overvalued depends a lot on what you think will happen to interest rates. If interest rates rise quickly in the next few years, stock prices could fall a lot further. On the other hand, if interest rates stay low, stocks could stay high.

News Flash: The Fed looks like they might be raising interest rates for the first time in a long time. The Fed’s policy making committee has meetings scheduled this year in September, October and December. Janet L. Yellen, the Federal Reserve chairwoman, has said that the Fed wants to raise its benchmark interest rate slowly over the next several years, gradually reducing its long-running stimulus campaign. The Fed has held short-term rates near zero since December 2008.

For the past 25 years, the Chinese economy has delivered impressive economic growth. Where the US economy has grown by 2 or 3 percent per year, China has grown by 7 to 10 percent annually. That growth was made possible by an export-oriented strategy that put Chinese people to work making products for international companies (like Apple).

The strategy has inherent limits. There's only so much global demand for this kind of work, and as China's living standards rise, it will become harder to compete with other low-wage countries.

To continue growing, China needs to branch out and grow its economy in other ways. Chinese companies need to produce more goods and services to sell at home rather than to export. And they need to become better at designing and marketing new products, rather than just manufacturing them for others (or making counterfeits).

Unfortunately, the Chinese economy isn't set up for this kind of internally driven growth. A big share of China's economy is controlled by bureaucratic and perpetually money-losing state-owned enterprises. These companies are insulated from market forces, and as a result they often make production decisions based on political rather than commercial considerations. For Capitalism to work, the government needs to keep its hand off and let the natural market place drive production. This is a lesson the current U.S. government needs to remember and China and socialist Europe needs to learn.

Over the last year, there have been growing signs that the Chinese economy is slowing. The official growth rate is 7 percent over the past year, but it's widely suspected that this figure is too high. Their real growth rate is lower. Even some Chinese officials have privately admitted that Chinese economic growth figures are unreliable.

In mid-2014, China's stock market began to boom despite the country's increasingly gloomy economic outlook. By early 2015, the government became concerned that stocks had become overvalued and began taking action to slow thing down. This triggered the stock market decline that began in June 2015.

In July 2015, China took a number of drastic measures to try to stop the market's fall. In the process, the government tied its own prestige more tightly to the stock market. That made it particularly embarrassing when stocks began to fall again last week. China’s leaders do NOT like to be embarrassed.

The real danger for the government isn't just that China will fall into a recession. It's that a plunging stock market and economic downturn will shake public confidence in China's political institutions more generally. The Chinese government has made rapid economic growth a central part of its bargain with the Chinese people. If that growth falters, it could do real damage to the government's legitimacy.

The West is no better off.

The Chinese economy is big, but it's not so big that a faltering Chinese economy necessarily spells doom for the West. There are, however, two reasons that a declining Chinese economy would be bad news for publicly traded companies in the United States and Europe.

One is that many Western countries are still suffering an economic hangover from the 2008 financial crisis. Ordinarily, central banks fight recessions by cutting interest rates. But in both the United States and the Eurozone, short-term interest rates have already fallen to zero. Where can you go from zero?

Central banks' other option, known as "quantitative easing", is controversial. The Federal Reserve and the European Central Bank use it sparingly.

In "quantitative easing", a central bank first inflates its own balance sheet by creating more money out of nothing. In a sense, it just prints more paper money. Then is uses this air-money to purchase paper “assets”.

Central banks do not buy things like land, diamonds, gold, or silver from commercial banks, but rather it buys debt in the form of paper: treasury bills / notes / bonds and Mortgage Backed Security (MBS) paper. It is really using air-money to buy debt.

Essentially, a central bank (like the US Federal Reserve) buys financial assets from private institutions and commercial banks (like Citibank), thus injecting money (out of thin air) into the economy. Since interest rates are already zero, this cannot impact the price of money (interest rate), it can only impact the quantity of money. The danger is hyperinflation.

Secondly, there is the problem of a sluggish economy in the West. The result of poor management at the top of the economic food chain is a sluggish recovery in the United States, and even worse results in some parts of Europe. And that economic sluggishness coupled with central banks' failed attempts to boost the economy, spells trouble; like fire-breathing dragon trouble.

The companies listed in American and European stock markets are disproportionately multinational firms that do a significant amount of business in China. Consider Apple for example. Apple is a big player. About 25% of Apple's revenue comes from China, so an economic downturn in China is a big deal for Apple, and for Apple investors in the West.

It is possible that the recent stock market downturn, the devaluation of China’s currency, the meltdown of Greece and the stagnation of the European economy, is nothing to worry about (I said it is possible, not probable). On the other hand, we could be seeing the first tremors of a big economic earthquake.

So what should we do?

For one, we can start by getting our own financial house in order. Talk to licensed financial advisors to review your own portfolio; but do somethings on our own, too.

Start by reading Power Tools to Slay the MONEY DRAGON.

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