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How Low Can This Market Go?

  • What started this chaos in the first place?
  • The cracks in the system that will become obvious in time.
  • How the next few days, weeks and months are likely to unfold.
  • Summary and how to plan your investments.

I realize that everyone is expecting a number. I will get to that in the summary (do not skip down yet as the rest of the article will tell you how we get there). Understanding is the best basis for making investment decisions. First, I want to explain how we got to this place, what the potential problems are and how the whole conglomeration of situations we face will unfold. So, we are going to peel the onion, so to speak, one layer at a time so we can prepare for what may be coming our way. You be the judge as to whether this story makes sense.

What started this chaos in the first place?

It often begins with denial, which only makes things worse in the end. By denial I am not trying to blame our government, the Federal Reserve (well, maybe a little because it should have seen this coming and probably did), the financial institutions (well, maybe a little for all the little things that add up to big things which I will explain in a moment), or the financial talking heads (how can I blame the child-like innocence of the misinformed).

No, the denial was present in a few areas of the global economy where nobody was looking. First up is China, the magical land of impressive GDP growth. When imports are down and manufacturing is contracting the Chinese government tells us that domestic consumption is growing at a staggering ten percent rate, offsetting the other problems in the economy. Does that make sense? Imports are falling. Less stuff to buy from outside of the country. Manufacturing is contracting. Less stuff to buy from inside the country. Explain to me how consumption is growing when there is less available to buy…for months now. Domestic consumption is the one piece of the Chinese GDP growth picture that cannot be accurately estimated by outside sources. Imports and exports are all reported and verifiable based upon shipping traffic. Until the purchasing managers' index becomes more manipulated it provides the outside world with a decent view into manufacturing. So, I cannot help but suspect that the central government of a centrally planned system that controls all official communications might decide to report numbers that make the leaders appear to be "in control."

This situation has been obvious to me for some time, but who else wanted to consider the possibility because that would mean the world as we know it is not really the world as we know it. No one wants that. So, we all keep denying the obvious and assume it will all work itself out because the leaders are in control.

Then money flows out of China made the headlines and some people got worried. But those with cooler heads reminded us that this, too, was a normal extension of a nation growing at a robust rate. The rich merely wanted to diversify their holding some and expand the reach of the Chinese economy by buying up assets around the globe. The first rounds of this type of activity were actually just that. But then, it was more investing in assets that had no relationship to the Chinese economy at all: real estate in English-speaking cities as housing for college-age children and for rental income and potential appreciation. Then wealthy Chinese began buying more real estate in an attempt to relocate more of their wealth. Some of the billionaires in China were selling some of their prize holdings and reinvesting those funds outside of China. It has been a slow process over several years but the pace has increased dramatically in 2014 and the first half of 2015. Now it is reported that nearly half of Chinese millionaires are planning on leaving China by a study conducted by Barclays and Ledbury Research and reported by CNBC. Why are wealthy Chinese investors not investing in the Chinese economy if it is growing so rapidly? Would not the opportunities have far more potential for outsized gains in an economy that continues to grow at seven percent per year? The wealthy know the answer to these questions. The growth is not what it is reported to be and the opportunities are not as abundant anymore. Thus, the money is searching for better returns and safety elsewhere.

Foreign investors began to get a little leery of the huge stock market run up in the Shanghai Index of more than 100 percent in one year and started to take some profits. Local Chinese investors, many of whom had never invested in stocks before, were opening accounts at a record pace as equities leaped higher. The easy money had already been made in China's real estate market and now needed somewhere else to go in search of better returns. About 70 percent of the wealth of Chinese individuals is invested in real estate. Only about 15 percent is invested in stocks; or it was 15 percent but is a lot less now. Once foreign investors started leaving the market began to decline and many of the locals decided to get out while they still had some profit left. Stocks now went into a free fall, declining by more than 30 percent in a little over two weeks.

(click to enlarge)

Source: Zero Hedge

In steps the Chinese government with a multitude of new laws (from Bloomberg) in an attempt to stop the bleeding. The first attempt worked for one day. Then stocks began to fall again. Another round of government intervention stopped the fall for another day or two. Then the crash continued. Finally, the Chinese government pulled out all the stops and allocated nearly a half billion dollars to a fund to buy stocks and prop the market up. That lasted a little longer. Apparently, the fund may have run out of money because the Shanghai Index has continued its crash the last few days unabated.

Suddenly, everyone is looking for the reason and now it seems that the consensus is that slowing global demand is the culprit. Commodity prices have been falling for several years. Copper, the metal use in more industrial and construction applications than any other continues to fall because of lacking demand. This is not new news. It has been happening for us to see since 2011. Does that sound like denial?

So now that we are beginning to admit to ourselves that demand is, in fact, slowing and is the culprit, we are forced to face the reality that the global economy does not project the rosy picture we have been wanting to believe. So, how did all this start? Investors around the world have been forced to face reality and reality does not please them, especially in China. It is, after all, perception that really counts. And for not, at least, perception has turned negative.

So that is how it started but there are other cracks in the global economy and, yes, even in the U.S. economy, that are beginning to show.

The cracks will become obvious in time

Slowing global demand is not the same thing as shrinking global demand. What we will be facing in the near future is shrinking global demand as corporations and individuals realize that it is time to retrench again. It will not take much to push the teetering European economy into recession. Likewise, Japan is near the brink. The emerging markets will stumble inevitably due to the close dependence upon the Chinese economy. This is already happening but is just beginning to be reported in the news. This is the first crack in the global economy.

The second crack resides in the junk bond universe. The primary cause will be seen as the energy sector in the U.S. which issued enormous amounts of high yielding debt to finance lease and property acquisitions and still more to finance drilling and other capital investments. Hundreds of billions of dollars have been sunk into the fracking industry because the price of oil was above $100 per barrel and would never go below $80 again. At least that was the prevailing belief because everyone thought that Saudi Arabia would cut production to prop up the price of oil. Surprise! If you want to understand the rest of that story please see my recent articles on the energy sector outlook here.

This crack is getting wider and threatens to engulf much of the junk bond industry. Think about it for a minute. When more and more small (and not so small) energy companies go through bankruptcy those bonds will be next to worthless. As the equities markets around the globe fall, the risk premium investors are willing to accept on high yield bonds must increase. The result is that the rest of the junk bonds denominated in U.S. dollars go down in value and investors begin selling, prompting even more downside and a larger spread. Not only will questionable companies in the U.S. come under greater financial strain with the cost of borrowing rising, there are a lot of high-yield bonds issued to companies in emerging markets that will take a hit, too. Because the currencies in those countries are less stable, cheaper rates could be obtained by issuing debt in U.S. currency denominations.

This leads us to a third crack that is even less obvious. Emerging markets [EM] account for most of the global economic growth right now, outside of the U.S. (which is slipping also). I still count China in this EM group. The stronger dollar has caused many EM currencies to fall in value relative to the respective trading partners and it has increased the cost of capital that is needed for further expansion. The slowing has only just begun. And the defaults on U.S. denominated junk bonds issued by companies in the EM countries will bring more pressure to force yields even higher to account for the added risk. This could put the entire junk bond universe at risk on a global scale.

Another crack in the system is the rising proportion of car loans, especially for used autos, that are being made to subprime buyers (from NY Times). Remember the subprime mortgage mess in 2008? This problem is much smaller, but it could hit both the financial sector and the auto industry very hard as the number of such borrowers getting behind on payments continues to grow. Remember, if a recession starts the subprime borrowers will take the brunt of any layoff activity. And a recession is definitely in the cards now as reality begins to dawn.

How the next few days, weeks and month are likely to unfold

All of this is based upon opinion after having tried my best to understand all the pieces and the use of logic to determine how, or if, the unrelated events and circumstances may fit together. That is what we all try to do in analyzing a company or a situation. We review as much of the disparate evidence that is available to us from all possible sources that we find and use logic to piece together a picture that makes sense to us. So, here is what makes sense to me going forward.

There are really two primary keys to watch to discern how much more damage the global economy and, by extension, equity market are likely to sustain. The timing of the events will be hard to determine until we see them unfold, of course. But we should be able to determine the direction of the trend from day to day and week to week based upon the severity of these two factors: the Shanghai Index and the WTI crude oil price.

The Chinese government has certainly not run out of money that it could use to buy stocks to support the market. Has it already run through the almost one half trillion dollars already? Hard to say. But if the government is the only buyer, which is understandable considering what we have witnessed thus far, the selling pressure would eat through that in a few days. It has been a few days already. Will it commit more or will its leaders let the market fall more before trying to defend the market? Keep an eye on the Shanghai Index. If buying returns it may just be the government meaning that the slide could continue again after a reprieve.

Most Chinese retail investors have never invested in stocks before last year when brokerage accounts were opened at record rates as the market screamed rapidly higher. It looked like easy money. Now it looks a bit different. Greed has been replaced by fear and every time the market rebounds I expect those who have not bailed yet will do so. If the market does not bounce they will continue to sell in panic. In other words, the Shanghai market may tell us when the fear has cleared from the Chinese equity market.

The bigger worry is that the fear washes over into real estate. If real estate value begin to tumble in Beijing we will have a much larger problem to contend with and it could prolong the pain for the rest of the world for months longer than otherwise. This does seem within the realm of possibilities since many of the tier 2 and 3 cities have been experiencing falling prices for real estate. If it spreads to the remaining major cities it could begin to feed on itself.

The second factor to watch is the price of WTI crude oil (Bloomberg). If it continues to fall or even if it just remain below $40 (Bloomberg, where it is now, it could wreak havoc in the energy sector. That, in turn, could lead to a collapse in junk bonds worldwide. All those investors taking on more and more risk reaching for higher yield could find their nests filled with lumps of coal instead of golden eggs.

If the junk bond market collapses, it will most likely push the U.S. economy into recession along with China, Japan, Europe and most of the rest of the global economy. Then come the layoffs. The next shoe to drop then will be auto sales. People without jobs will no longer be able to make payments on cars they couldn't afford in the first place. All the subprime auto loans and the financial institutions that own them will become suspect. That will amount to another negative jolt to the system. Next, home sales will begin to slow down as demand diminishes and values could begin to fall back to earth her in the U.S. once again.

Then again, maybe the Fed will find a way to contain the problem to equities and energy bankruptcies. Perhaps it could just start buying stocks to support the market. I do not claim to have any clue as to what lengths the Fed will take to save the financial system and all those saintly bankers. Maybe I have become paranoid and am reading way too much into the situation. Then again, maybe not. I am fully hedged so I don't have a horse in this race either way. To be clear, I would rather be wrong and have everything come up roses.

In conclusion, to determine whether things will continue to get worse or better watch the two key factors I mentioned: the Shanghai Index and WTI crude. If both continue to show negative signs it will most likely get worse and worse until those two things improve to tolerable levels. If WTI crude miraculously rises to over $50 per barrel and the Shanghai Index begins to rise again then the world as we know it will likely not end today. Watch them, not just tomorrow or the next day, but for the next two to three months. Things could and probably will seem to get better for short periods just to turn negative once again. Or maybe not.

Summary

Okay, I promised you a number at the beginning of the article and now I am going to explain how we get to the right one. You may want to relax for a few moments and indulge in your favorite libation(s) as you may need a steady hand. This process is tried and true and certain to provide the answer you seek.

First, you need to take into consideration the information with which you are now armed from reading this article. Think about it and make some decisions as to which pieces you agree with and which ones you do not. Let those convictions guide you in determining you expectations and proceed to the next step.

The best way to make a prediction of this nature is to look at the charts of the major index you like to follow and identify the levels of major support. If you are unfamiliar with the technical analysis required to perform this part of the process you can find an easy-to-understand explanation of identifying support levels here.

Then write each of those numbers down, each on a separate piece of paper. You can vary the size of the pieces of paper if you want. The next thing you need to do is get out the old dart board and hang in on the wall. Then fasten the pieces of paper on the face of the dart board in a random order using whatever form of adhesive you prefer. I like scotch tape.

Now comes the most scientific part of the analytical process. Holding a dart in your hand at about ear level, take careful aim at the piece of paper you want to hit and let the dart fly! If you are unhappy with the first projection try using a different dart. You may have picked out a faulty one on the first try. How else could the result have been so disastrous? Repeat as many times as needed to achieve the outcome you desire. You should be happy and confident now. The best part is that you have identified the bottom that you want and expect to occur. You are probably just as close as all the pundits and financial talking heads are going to be. I believe they use slightly different analytical techniques but the outcomes will generally be the same.

Seriously, the best way to invest when the markets are going down like this is to take out your list of favorite companies that you have been unable to buy because those stocks always seemed to be overvalued. Pick a price at which you would just love to own that stock and you would expect it to provide you with significant appreciation potential and a great yield over the long term. Start buying in increments of perhaps a quarter of the total you would like to own as a full position.
When the market has a really terrible day and takes your stock down with it, if the price of the stock hits your wish price, pull the trigger and get that first piece.

In case the market might go even lower, determine another even lower price at which you could not resist buying more. If the stock hits that price add another portion to your position. Keep this up until you have your full position in place. Then sit back and stop worrying. If you bought stock in a great company with bright long-term prospects you will do fine in the end.

In essence, I am telling to do the obvious. Buy great companies when they are on sale! Let me provide an example that easier to understand.

Let us say you own a nice dining room table but could only afford two chairs when you made the initial purchase. Later on there was a sale on the matching side chairs that you need, but you could only afford two more at the time. You probably bought those and now have four chairs.

But now there is a going out of business sale at the furniture store and it is selling the chairs at ridiculously low prices. It also has two of the leaf that would fit into the table when fully extended and those are on sale as well. You can make one of two decisions:

  1. You could scream and panic because suddenly you realize that the price you paid for the original table and chairs was way more than you would have been able to buy them for if you had waited. If you get really mad, you may even sell the table and chairs you have now out of desperation because those items have lost so much value. You would take a big loss, but at least you would not have to look at those pieces of furniture that you were taking a terrible beating on because of the lost value.

Or…

  1. You could take advantage of the sale and complete your dining room set the way you had always wanted! Buying the chairs and the leaf will now allow you to entertain in style with larger gathering. Having taken advantage of the sale prices allows you to live the way in which you have always dreamed.

I hope you realize that buying furniture, or anything else for that matter, is little different from making good investments. If you can buy what you want when it is cheap you end up in a much better place financially. Buying the stocks you always dreamed of owning when the prices go way down provide you with the opportunity to improve your future. I will always choose option number two and I hope you do the same. Good luck!

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.


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