The China syndrome, or why the market crashed

The Dow Jones Industrial Average closed on Aug. 21 at 16,459, or down 1,893 points from the high of 18,351 on May 19, 2015. In this three-month period, the Dow lost 10 percent of its value. By comparison, the Chinese Hang Seng Index (HSI) stood at its high of 28,548 just about a month before the Dow hit its high. In the ensuing three months, the HSI fell to 22,105, or a decline of 6,145 points, which amounted to a 21 percent decline. The chart below gives you a visual representation of the two market declines: While the magnitude of the Chinese decline was greater than that of the U.S.’s, the chart patterns are similar.

Many people wonder why there was such a precipitous decline in such a short time in both markets. I believe there is downside in both markets, but I believe there’s greater risk in China than in the U.S. Growth at any cost has been the philosophy of the Chinese government. A growing population and the movement of people from the agricultural environment into the cities have placed a great deal of pressure on the government to find jobs and keep the economy growing.

If you include the European Union, currently the United States is ranked third in the world in terms of the size of its gross domestic product (GDP). China is first, the EU is second and the United States is third. You could describe China, because of their export power, as a cash cow. It exports more than it imports and it needs this cash flow in order to keep its economy growing. The Chinese economy in one quarter has seen GDP growth equal to the entire GDP growth of the United States during the entire Obama administration.

{mosads}This growth has not come without consequences to their economy, their currency and their stock markets. The debt-to-GDP ratio of the central government is out of control. According to an article in Forbes, on May 9, 2014, the total debt-to-GDP ratio was 282 percent. The direct government debt is 64 percent of GDP, but the government is a big participant in state-owned entities (SOE).

The financing of real estate development, highways and factories, just to name a few, is supplied by these SOEs and some of these transactions have been brought to the exchange to sell to investors. Now the underlying economic assumptions are rapidly deteriorating and, in turn, the market value of the investments. Investors are concerned the high-growth rates of the Chinese economy, which is dependent upon exports to grow, will decline with a global slowdown in economic activity. China will find itself with ever-increasing excess capacity. State-owned enterprises will find themselves potentially having to reduce their workforce or close factories because of lack of demand; it is possible that it is already happening — we just don’t know about it yet, but investors do.

If the SOEs run out of money to operate their businesses, then they will look to the central government to bail them out until times get better. The thing that strikes me is how ill-equipped the leadership of the central government was in dealing with this financial crisis. It is this lack of experience that may present the greatest danger to investors and their capital. The government decided to let the yuan float. The decline was in excess of 6 percent and with lower revenue from less imports, China has a cash flow problem, especially if the economies around the world continue to slow. When investors get nervous, they sell, and that’s what’s been happening over the last three months in China. Investors seem to lack confidence in the government’s ability to solve the country’s problems.

I was fortunate enough, many decades ago, to be involved with some Swiss bankers in developing the first sovereign debt mutual fund in the United States. I asked the president of the bank, which was managing the non-U.S. government debt obligations, what was the difference between Swiss investors and Americans? His response was that Americans tended to make investment decisions based on emotion, while Swiss bankers made decisions on the fundamentals. If the fundamentals are strong and the market sells off, then the Swiss see the decline as an opportunity to buy. As a money manager with over 40 years of investment experience, it is still hard to follow the advice of my friends, the Swiss bankers. On days like Monday, it is difficult to not sell.

The question is: Will this decline continue or has it reached the bottom? I think there is the greater possibility of a continuing significant decline in the Chinese market than the odds of a significant further decline from this level in U.S. markets. The 10 percent decline in the U.S. market is not an unreasonable correction in a bull market. The chart above shows the 200-day moving average of the Dow over the last three years. Follow the orange line; every time the blue line drops below the orange line is a breakthrough of support. Therefore, the next level of support on the Dow Jones is 15,935, roughly another 500 points down from the close on Friday.

Perkins is a registered investment advisor with over 40 years of investment experience investing money on a global basis. He is also the author of The Brotherhood Of The Red Nile trilogy, a story of Islamic nuclear terrorism against the United States.