Mr. Market comes knocking

Global stock markets have had a really poor start to 2016, with China being the principal culprit.  The Shanghai Composite Index has hit its 7% trading curb several times so far this year while being down another 5.3% on Monday 1/11/16.  The trading curbs are new, installed by a government that thinks it can mandate control over things like human reproduction, air pollution, and social media.   Traders did a turn tail and run on Monday 1/04/16 and haven’t looked back.  Here is the price activity that precipitated the trading curbs.

06/03/14 Shanghai Composite Index =  2,038.30                                  S&P 500 =      2,114.07

06/12/15 Shanghai Composite Index =  5,166.35            +153%            S&P 500 =      2,094.11          –    1%

08/26/15 Shanghai Composite Index =  2,927.28            –  43%            S&P 500 =      1,940.51          –    7%

12/31/15 Shanghai Composite Index =  3,539.18            +  21%             S&P 500 =      2,043.94        +    5%

01/04/16 Shanghai Composite Index =  3,296.25            –    7%             S&P 500 =      2,012.66         –    2%

01/07/16 Shanghai Composite Index =  3,125.02            –    5%             S&P 500 =      1,943.09         –    3%

There are several takeaways from this chart; buying the SCI on 6/03/14 and selling it on 6/12/15 would have been a good trade. Owning the SCI would have increased volatility for virtually any portfolio and the S&P is not highly correlated to the SCI.  Conclusion….it’s the Chinese economy causing problems in our domestic markets, not the Chinese stock market.  Financially, China is still a closed market.  Westerners can’t have direct ownership in Chinese companies and there is no way for them to own the SCI.  They can, however, buy ETFs like the iShares China Large Cap ETF…. which does a woefully inadequate job of correlating to the SCI.

At P&A we have yet to take the China “bait.”  Our pro forma weight for emerging markets is 5% of which China represents about 1%.  This has not been a great place for money as of late so no complaints.  The Chinese economy, however, is embedded in almost every U.S. company that does business there or in the Pacific Rim.  So therein lies a pretty significant conflict.  Financial investors are locked out of the investing side of China but trade partners participate in all the peaks, valleys, and potholes.  Kind of like being able to do business in Kansas without being able to own a business in Kansas.

So as the Chinese economy slows, investors in the Pacific Rim and other Chinese trade partners feel the pain.  As those stocks decline in price there are no natural buyers for them…..the man on the street in China is not allowed to buy them and the westerners who already own them have a basketful.  But liquidity demands do not go away…..investors can decide not to buy but they can’t decide to sell.  When investors and trade partners need cash, they need cash.  To that end, they sell what they can sell and more often than not, that means U.S. stocks and bonds.  I subscribe to the idea that it takes a 16% decline in the Dow or S&P to end a bull market and a 19% rally to kill that bear and initiate a new bull.  If you like to play with numbers, these two values are the complement of one another and they set up the historical events that surround most corrections quite nicely. The financial press likes to chatter about 10% corrections.   I think they like that number because it is simple and they are too impatient to wait for the 16/19 setup.  We are close to another 10% correction from recent highs and it is getting a lot of press.

2016 is looking like a bittersweet year.  I will not be surprised if we are able to do quite a bit of loss trading as the year goes on.   I will also not be surprised to see the popular averages finish higher in December….think high single digits.  As discussed in our latest quarterly letter, we are constantly reviewing and rebalancing portfolios.   Consistent with that process but not discussed in this letter is our search for new investment candidates.  As the markets correct, stocks become easier to pick.  Look for downgrades by major brokerage houses, they make stocks easier to pick.  The stock market is one of the only markets that customers flee when prices go down.  As that happens, stocks become easier to pick.

Most of us know that things are not always as they seem.  Erroneously blaming the Chinese stock market when the economy is actually at fault may seem like small potatoes, but understanding is one of the keys to holding securities long term.  Before we leave this subject I would like to offer some knowledge that has been learned while studying for an advanced degree at the University of Hard Knocks.  Every day there are stock market buyers and sellers, orders are matched and the exchange systems give each side the best available price.  A significant percentage of the sellers have to sell.   A much smaller percentage of the buyers have to buy.  When they don’t buy at a given price, market makers lower that price.  In a robust market, a 1,000 share sell order can be expected to fill at the advertised bid.  In a frightened market the same trade might fill 100 shares at the bid, 100 at bid less an 1/8th, 100 at bid less a quarter, 100 at bid less 3/8ths…..you get the picture.

Once the nausea clears, the usual suspects will still be sellers.  People need money to live on and a significant percentage of the national wealth is held in equity shares.  The rats always climb back on the ship, buyers will eventually take their hands out of their pockets and start to compete for the offered shares.  When they do, greed will accelerate the process.  Picture yourself at an estate auction during a blizzard….how aggressive do you bid?  How about a farm auction when the grasshoppers are swarming?  Dedicated sellers and buyers without commitment produce lower prices.

The gains earned in 2016 will not come easily and they will test your patience.   They will test ours, too.  We continue to “Really Like” stocks and are closer to “Love” than “Like.”

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Since 1995, Pittenger & Anderson has guided individuals and families going through money-in-motion events. We are a fee-only Registered Investment Advisor and a full-time fiduciary providing investment management, financial planning, and complimentary services to 700+ clients in over 30 U.S. states.

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