U.S.A. & China

Anyone following the performance of the Asian markets this week can be forgiven for feeling a little uncertain about what's going on right now. On Tuesday, the Shanghai stock exchange tanked nearly 9%, bringing the Dow Jones down 415 points with it and making news across the world, the next day it rebounded 3.9%, Thursday the market slumped again nearly 3% and in today's trading it inched up 1.23% again. Tarrying the performance with other markets in Asia only leaves one more confused: on Wednesday when China was strong, the Hang Seng and the Nikkei continued their spiral in the other direction. Only the past two days have we seen some kind of conformity in Hong Kong and China's market performance, but it's safe to say that by and large results are mixed, and even then, as these markets have finally regained a small footing (the Hang Seng ended the day up 95.41 points yesterday at 19,442.01), Japan fell further today and at the time of writing the Dow is trading down 75 points at 12.159.44.

While all this is a volatility trader's reprise for the several months of straight vertical performance we've had in world markets, it doesn't say much about what's to come for the majority of us.

First of all, while there may seem like a general feeling right now that things are not good for markets, this is a gross over-simplification of what's going on, so I'll explain the general arguments and then then I'll give my take.

In China, the most widely-touted argument going around right now is that while market performance is uncertain and stocks may be overbought, the underlying economic growth of the country is actually pretty strong. In other words, keep buying into China and doing deals there, just stay away from the Shanghai and other regional stock exchanges right now. This has to be the most misleading piece of economic propaganda I've heard come out of the region in a long time. Just relate it to the argument being made about the U.S.A and you'll realize it makes no sense at all.

In America, the argument is that the economic performance of the country is slowing down, and so markets too don't look such an attractive bet right now. The U.S. global goods report released last week, indicating that perhaps we'd all just got a little ahead of ourselves with our positive forecasts, was in part responsible for the big reaction on Tuesday, and this type of data is still having an impact on the shelling spree we are seeing in the Dow, the NASDAQ and the S&P. In fact what we are seeing in the markets now is exactly the type of scenario I predicted we would see in Q3, it just came earlier than expected. This makes sense given the Asia context too, which many forecast as inevitable but "earlier than expected".

The point is, you don't get strong economic growth and slumping markets in an open economy - at least not for long, because such disparities contradict one of the most fundamental principles of macro-economics: that if there's a buying opportunity, someone will see it and snap it up. In other words, if it was possible that you could have a booming domestic economy with weak domestic markets, it wouldn't be for a very long period because it would be an enormous arbitrage opportunity that everyone would see and buy into until markets reflected economic performance, and the situation returned to parity.

So, if China's economy is still booming and America's is falling apart at the heels we should seize this opportunity to buy China and go along with all the bears in the U.S. and sell the Dow, right? Completely wrong, and here the argument gets slighty more complex. Once a market is established in a country as a primary force of capital entry and exit, that economy in which the market operates is to a large degree affected by that market's performance, with little abstractions. Remember the period 1996 - 2000? U.S. markets were surging upwards, and the economy followed. Business was created, companies had more capital to play with, and everyone by and large got richer; if they didn't actually get any richer they at least felt richer (i.e. that an opportunity was 'just around the corner') and they spent more, meaning business got richer again.

What China has done over the past few years is viciously promote its own domestic markets - sometimes to the point where she declared she had no need for U.S. capital since her domestic markets were flush with cash - and as a result, China has come to resemble a typical open market-based economy. Now, what happens to a market-based economy when it's way overbought? You can answer that question by looking at the United States in either 1929 or 1999/2000. The market spirals, and all the processes described above during that period go into reverse.

Here's a practical example. Let's say a year ago someone came to you with a hot new Chinese company idea and said "we're raising $50 million right now, do you want in?" You'd be stupid not to say yes. And what about if the same thing happened today? You'd be more hesitant, and so would everyone else, which means either the capital needed to start the company wouldn't materialize and it would never get off the ground, or that it would take longer to materialize and it would be delayed. Which means either no more jobs created by the new company or jobs created by the new company would come open later. The point is, either situation doesn't encourage faster, and deeper economic growth.

By taking such enormous state-owned companies like the big banks and industrials to market with such a fanfare, China has pegged her economy to the market, and what we are seeing now and about to see is the first example. Her economy is far more led by her local markets than people are willing to let on right now, or even realize. Just because the country is far away and has a billion plus people, it does not mean her economy works differently. A market-based economy is a market-based economy.

Now, in the U.S., we've all forgotten that even a year ago markets were way, way underbought given economic performance, so right now, that doesn't necessarily mean they are overbought. And they're not. The next few weeks will be a fun time for value traders to pick up some cheap deals which were just about looking like they were going to get too expensive quickly. And the economic data isn't that bad. It just says that the U.S. is a huge economy, and it takes time for huge things to grow (i.e. they don't grow at the same pace as they do in the much smaller emerging economies).

This is why my consensus is distinctly for now: buy U.S., sell China. It's not the end for China, but it is a longer term problem than people are making it out to be. And that's a healthy thing, because it shows how far the country has come on in resembling a fully-functioning open market society.