In The Short And Middle Term, It’s About China With Oil Hot On Its Heels

Monday Morning

At 12 PM in New York, markets seemed to be righting themselves after an indescribably volatile overnight session in China and then Europe that bled over to Wall Street. The CBOE Volatility Index (VIX) exploded to 53 after having tread water in the 10-to-20 range for most of the year.

As we write the first part of today’s letter, though, the Dow, S&P 500 and NASDAQ have recovered impressively. The Dow early in the trading day was down over 1000 points. Shortly after the noon hour it’s down “only” 230 points. NASDAQ’s recovery is even more intense. As of this moment it’s hard to predict for sure, it looks like the tech-heavy index could have some winners on the day although the average will stay down.

But let’s focus for a moment on Asia, especially China. The Shanghai main index was down almost 8.5%, the biggest percentage drop in eight years. We have been naysayers about China for a couple of years now and the recent decline – and responses from the People Bank of China – have reinforced our perceptions of China as a paper tiger, as Chairman was fond of saying about the U.S. back in Cold War days.

China has a fundamental problem that westernized economies do not suffer from. Simplified, that problem comes down to too few opinion-makers, too few investors with real clout, and too few people at the bureaucratic top of the heap to make sound decisions. The Western World is a crowd-sourcing world, not a dictatorship.

While it is really a misnomer, let’s call western Anglo-American economic systems “free markets.” Of course they’re not really “free” in the libertarian sense. But they are free insofar as you or your neighbor or your cousin in Nome or anyone can present a viewpoint, dump on someone else’s viewpoint, criticize the heck out of government actions and so forth. The west understands that, regardless of its annoyances and its own shortcomings, that the key to a vital economic system is a huge pulsating marketplace of ideas.

China – and Russia, as well – doesn’t have such a thing except as it operates in a very narrow band of business manipulators.

It is noteworthy that the current bout of volatility began immediately after China devalued its currency. That was a terrible move for world economic stability and while it may have benefited China in the short term, it will (and already has) hurt the country.

The surprise de-val has damaged dozens of other emerging economies, certainly led to further trust issues between China and the highly developed economies, and has put Japan, South Korea and Hong Kong on edge.

It has to be understood that on a variety of levels, trading is still a “handshake business.”

Trader “A” has to know that equity “X” is shooting straight when it comes to data, or the timing of news, or the health of a major executive. China has lied and lied and lied about the state of its economy. It has tried – and failed miserably – to move itself from the export model it leaned on for so long to a more services-reliant economy.

The trick that China cannot and probably will not master is this: a service economy much, much more than a manufacturing economy relies on openness and the free flow of ideas and opinion. Sounds dicey to us. China could never get there without a complete social revolution, something that neither its history nor current state of affairs point to as an easy layup.

It is the general atmosphere in the world’s second-largest economy that is holding it back now. We’ve seen it and cited their central planning missteps dozens of times in the last six months alone.

Monday Afternoon

At one point, West Texas Intermediate crude crashed through the $38 per barrel level and ignited a firestorm of worry. It has done so again at 3:30 in New York, a sign it is probing a new low. Unfortunately for equities holders, that price drop has added renewed momentum to the early morning sell off.

Unless and until oil recovers, there will be a heavy weight on American equities, especially the Dow.

In late afternoon trading, all three New York exchanges are trading off between 3% and 4%, granted well off their lows but nevertheless not on entirely solid ground.

A bit of an explanation can be found in the day-trading impact scenario. Let’s take a stock everyone loves to love – Apple. It started the day at roughly $108 and fell to $92 until CEO Tim Cook issued mid-quarter guidance pointing out how well the company was doing in China. That boosted the price back up to 107 and now it’s back down to about 102.

That kind of play is working out all over the Dow, S&P and NASDAQ.

As the drop in equities around the world unfolded, there was further selling off due to deleveraging by certain funds and bankers, especially in the developing world. That leaves us with another problem.

Selling a leveraged position leaves someone somewhere holding the debt bag. In the emerging economies, that will be China. In the second world, that will be the U.S. and Europe. You’d rather be among the latter than the former.

We think that gold prices are a bit tardy in reacting to movements in the equities and other markets. Gold was up immediately at the starting bell and then fell as equities recovered. In late afternoon trading, gold is beginning to come back with a strong assist from a weaker dollar. Yet regular traders seem to want to push the price of gold down, favoring, perhaps other haven plays like the yen and Swiss franc.

Wishing you as always, good trading,