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Why The Big Drop In The Markets?

Short answer… China.

For years, China’s economy has been humming along with GDP growing at about 7% to 8% - or so they say. Although China has made some market reforms over the years and introduced elements of capitalism into their economy, the Chinese economy is still very much controlled by the Chinese government. Still, even controlled economies can experience recessions and lagging periods. The Chinese government has “chosen” or aimed at growing at the aforementioned rates; if it was really that easy, however, then recessions or bad economies wouldn’t exist because growth could just be selected as if off a menu. China plays a major part in the global economy without a doubt, so any adverse news whether signaling slowing growth or worse, a recession, can cause turmoil in global markets.

Jim Chanos has been sounding the alarm on the Chinese economy for the past several years.

Jim Chanos, a successful hedge fund manager known for his short calls, has been warning on China for years. He has remained suspect on the data coming out of China and so have I. In fact, I stopped buying Chinese stocks back in 2011. One stock I bought seemed like a no-brainer with awesome returns on equity and capital; a stellar financial profile; and valuation ratios in the basement. I paid the price. Luckily, it wasn’t my only investment. I found that the numbers could not be trusted. I reasoned that China’s financial system was more along the lines of ours in the early 1900’s – trying to work out the kinks and become more modern. This meant weeding out accounting shenanigans and worse – fraud. That’s not to say that these things don’t occur anymore in the U.S., it’s just to say that we’ve responded with measures to hopefully prevent them.

Hedge fund managers aren’t all successful, and their advice is not all worthy of taking heed to, but Chanos is one of them. Regular Chinese people were encouraged to buy stocks in the Chinese markets on the belief that they were going to go up forever. The last few weeks have proven that notion unfounded. Remember day traders getting rich on their computers during the technology bubble? How did that work out? The music must stop at some point, and it’s at least at a lower volume today. When I started studying investing, I learned that when regular people start telling you to buy stocks – it’s time to sell. I dually learned that when you’re the most popular person at the party because you invest – it’s time to sell. I seem to get a lot of calls nowadays asking me what to buy and how to get in the market.

I’m reminded of the futility of GDP as a measure of the economic health of a country. GDP really doesn’t signify a country’s health at all. The fact that China was growing at 7% or 8% did not say anything about the means; it only signified the ends. The U.S. economy was growing before it wasn’t and went into decline. It wasn’t a snap of the fingers type of thing; it was adverse conditions building during that growth period. We’re growing at 3%! Great! Who cares if people are going into debt that they can’t repay and buying houses on credit. 3%! The chickens are likely coming home to roost in China as they did in the U.S. some years back. Much of the growth in China has similarly been fueled by debt and led to cities with no inhabitants and the proliferation of a shadow banking system. You can’t just pick a growth rate and get there at all costs without ramifications.

China’s devaluation of its currency hasn’t helped the situation either. Central banks in other Asian nations have responded leading to concerns of a currency war. This is not good for anybody and could potentially hurt the U.S. economy as the dollar strengthens not only because of natural economic forces but now artificial ones as well. The Koreas are once again back on the brink of war, and the dire situation in the North combined with the violent reign of its leader introduces uncertainty into the financial markets and poses a threat to peace around the world. Like it or not, the markets will likely remain volatile as these situations sort themselves out.

- Andrew Sebastian

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