This article was originally published on Quora.
We are getting to the point that not even mighty James Altucher with all the chocolate in the world can save this market.
1) Liquidity drives markets swings, not valuation
The stock market is more subject to liquidity flows than either company or country fundamentals. This is reflected in the famous quote from Keynes that "Markets can stay irrational longer than you can stay liquid" .
2) Money Flows into EM (and other assets)
An expansion in liquidity in a major country's economy drives up its domestic stock market, real estate, jewelry, collectibles, art, private firms, startups, etc.
When the US (world's largest economy) boosts liquidity some of the money goes into EM. The map below helps to illustrate the problem when part of US money is directed into tiny markets (I will address China next ).
World Map by free float market capitalization (in $ billions)
Currently, the value of all shares listed in Brazil (this is the 8th largest economy in the world!) adds up to $684 billion. That is about the market cap of Apple. Any small change in investment sentiment by Fidelity, Vanguard, PIMCO, etc. which leads to a decision to over weight vs under weight a certain market causes huge swings (volatility) in the local market.
3) EM markets investors are overwhelmingly short duration
Unlike US or European markets, there is a lack of long term value investors in EM. These are pension funds, insurance companies and wealthy people (a.k.a. Warren Buffet types). That means that in the US, markets will bottom much faster (lower volatility) than in EM where most of the volume is made of hedge funds, prop desks and market makers (momentum investors).
4) China
The problem as some have spotted in the picture above is that China seems deeply under estimated. That is because the graph excludes A-shares and others that cannot be owned by foreigners. Adjusting for that, Hong Kong, Shanghai and Shenzhen are about one-third the size of US markets. That means that China is about 10% of global stock markets and this is not as trivial as Brazil or Russia.
The Chinese (and other EM) sovereign balance sheet is upside down with a big pile of debt and very little room to maneuver. As the government gets more desperate to reverse years of bad policies, it is naive to think the unwind will be mild. In July, after a meeting of between Chinese regulators and the heads to the top 21 brokerage houses we saw the following:
“The firms announced in a joint statement that to stabilize the stock market they would spend at least 120 billion yuan combined to buy exchange-traded funds linked to blue-chip stocks listed on the Shenzhen and Shanghai. Moreover, the firms pledged to hold all stock that had been bought with their own money until the index reached at least 4,500 points.”
As one analysts pointed out: if you are long the underlying asset and short a call option, you are effectively short a synthetic put option struck at the same price as the call option. This means that anyone who buys Chinese shares is short a complex synthetic put option on the market. If this is not bizarre I don't know what is.
China is extremely corrupt (same in other EMs where governments are still trying to make Socialism 2.0 work) and with an aging population. So a lot of so-called investment is wasted. That is because the increase in future consumption caused by the higher theoretical productivity the investment would generate will NEVER materialize simply because some projects are questionable and lots of money ends up in the hands of few.
5) House of cards
As Stephen Roach wisely pointed out: "You either believe in Globalization or Decoupling". You see people in CNBC and other so-called experts arguing for both. James Altucher is right that the media doesn't know anything. I prefer to believe they are stupid rather than liars. The world in increasingly globalized and there is no decoupling. Investors may overlook bad government decisions, but only for so long. Decoupling is a temporary illusion.
Let me bring it all together with a real world example and show how China and other EM can affect the US market. It has nothing to do with international trade and exports, but with built in self reinforcing loops in the system.
If you speak to real estate agents in NY or Miami they will tell that their international buyer has paid cash for their $10m condo and there is no reason to worry. They say their Russian/Chinese/Brazilian clients are not like the Americans who need a mortgage, they show up with $10m cash. Park that also in your mind for a moment.
Putting all parked pieces into into motion. As EM slows down, the EM wealthy guy makes less and less money from his business, he may even have to put more cash to keep the business afloat (I personally know people doing this already).
So James Altucher I suggest you book your trip to Shanghai with a stop in Switzerland because the Chinese like the good stuff and Hershey's is not going to cut it.
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