The wild ride continues today. As I’m sure anyone with so much as a radio has heard, the Dow Industrial Average opened and promptly sold off almost 1100 points. Regardless of who you are or what you do for a living, that’s not easy to watch. After bottoming within a few minutes after the markets opened, the major indices quickly cut those losses significantly. It’s still going to be a crazy day, and likely week, for stock investors.
This is all being driven by the topics we wrote about Friday but probably is worth diving into a little deeper today. To start with, it’s worth saying that an investor should never trade in a volatile market like we’ve had today. Traders on the other hand, (good ones), love days like this.
I would define stock investors as people who are buying equities based on multi-year trends and fundamental analysis. They are reasonably expecting to see the share price change over time based on average increase in earnings (per share profits) of that stock or group of stocks (index) over their holding period. For that expected increase to hold true, the average must be realized over at least several years. This is because funny things can happen in any given year or two, but seldom over longer periods of time.
It is also important to understand what you’re buying when purchasing a share of stock. The share price should represent the current value of all the future profits of that company. If you’re buying an index, like we do, then it would be the future earnings of all the companies in that index. For the share price to go up, the earnings must grow year over year. The earnings growth of an index tends to be fairly predictable and this is why we view them as a safer way to invest than buying individual stocks. Something unexpected can happen to one company that can impair their earnings for a long time.
The biggest risk to stock investors usually comes from themselves. Everyone knows that to make money in stocks you need to buy low and sell high. However, most people’s natural instinct is to do just the opposite. They see a big move in the markets and feel like they need to do something about it. The reaction today would be to sell when the Dow was off 8 or 9 hundred points. Two hours later the Dow is off 300. By being “safe” they just lost a 3% spread.
Days like this are for traders. Traders love these markets. To be successful, traders need volatility. The more volatility the better their chance to profit. It’s also fraught with the potential for losses. But that’s the game traders signed up for. To be a successful trader you want to look for stock prices that have become disconnected with reality or where there’s a big imbalance between buyers and sellers that you think will get corrected in the coming hours. These opportunities are hard to find during normal trading days, but plentiful on days like this.
So let’s look a little deeper into what’s driving the stock market lately. We had mentioned Friday that the markets were taking their lead from the events in China. The reason for this is that China wields a significant amount of influence over global trade due to their 1.4 billion person consumer base and $11.2 trillion GDP. With those sort of numbers, it’s hard for businesses not to have some level of contact with them.
As China’s influence has grown, so have the concerns about them. We live in a very connected world and you can’t help who you’re competing with. A U.S. auto manufacturer has to compete with a Chinese manufacturer for the same steel. The same holds true for the Indian power plant buying coal or a Japanese firm buying semiconductors. Firms also don’t have to sell directly into the Chinese market to be effected. Their product may be one part of something else that is sold in China. Chinese firms are out there bidding up prices on parts and materials that are used worldwide.
One of the biggest concerns is the lack of transparency in the country. China is ultimately a communist country with very loose standards when it comes to laws and regulations. Economic news and statistics are carefully filtered by the government so no one is really sure if they can trust the official information released – assuming it even is released. This makes getting at the truth a bit of a guessing game and analysts have become very creative at figuring out what is going on.
The current drama is centered on the health of the Chinese consumer. We know that individual debt has been rising in the country and that many Chinese investors have lost significant sums of money in their stock market this year. We know the situation is bad because of the extraordinary measures their government has taken in an effort to reverse those losses. In a true central planning way so common in communist regimes, the government has placed a number of trading restrictions and purchasing plans in place to stem the flow of losses in those markets. This combined with a currency devaluation by their central bank have failed to turn the situation around. Thus the global markets worry that things are spiraling out of control in China.
Financial markets loath uncertainty and there is a lot to be uncertain about. Thus we have a global selloff in stocks. Our view is that the response is overblown. While these concerns are legitimate, when you put the numbers to the possible outcomes, the economic impact to our economy doesn’t justify the level of panic we’re seeing. This feels like a purely news driven event and not one based on the fundamentals. History has shown that those types of selloffs tend to reverse themselves quickly. This in no way looks like the last correction we had in 2009.
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