The Opinion Shift That’s Hurting Stock Markets

Depressed Businessman

In case there was any doubt, the US Federal Reserve is still the big dog on the block. On Tuesday, everyone’s former hero, the People’s Bank of China (PBoC), cut interest rates and reduced the ‘reserve requirement ratio’ by 50 basis points.

The market rejoiced for a few moments. Then resumed its panic over China’s slowing economy and the effect on the rest of the world. Chinese stocks rallied, then sold off. At the same time, Wall Street opened sharply higher, but finished the day lower.

In short, the market called the PBoC’s bluff. It eased policy because of the extreme weakness in the stock market and rapidly slowing economic momentum. But the effect was minimal.

On the other hand, it took just a few words from the Fed overnight to give the market a boost, or at least contribute to the positive sentiment. From Bloomberg:

Global market turmoil has weakened the case for raising U.S. rates in September, Federal Reserve Bank of New York President William C. Dudley said, cautioning that it’s important not to overreact to short-term developments.

“From my perspective, at this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago,” Dudley told a news conference Wednesday at the New York Fed.

The Dow Jones index surged 620 points, or nearly 4%, signifying faith in the Fed is alive and well.

But don’t be deceived. A 4% surge in the market reflects short covering rather than fresh buying. The crash of the past few weeks inflicted major damage on the bulls, and it will likely take some time before they get their mojo back.

Keep in mind too that the market would have probably rallied overnight no matter what the news. That’s what happens after massive sell-offs. The market bounces in an attempt to restore some balance.

I wrote as much in a special update to Crisis & Opportunity subscribers earlier this week. I said:

Stock prices tend to move back towards their moving averages after big moves. It doesn’t matter whether we’re talking about rallies or declines.

You can see this dynamic at play in the broader market too. The chart below shows the ASX 200…the index is over 400 points below the moving averages. This is a very large gap. It stands to reason that the market will attempt to rally to fill that gap.

The extent of the rally will give us clues as to just how weak this market is, and how badly the recent sell-off has damaged investor sentiment.

The moving averages I refer to are the blue and yellow lines on the chart below. They smooth out the daily market volatility and give you a good idea of the market’s underlying trend.

Prices tend to hover around these moving averages. When they go too far in either direction, you usually see a bounce back. That’s where we are now. The index is simply recovering from a huge panic sell-off.

Source: BigCharts

If the market does rally back towards the moving averages, you could see it get back to the 5,450 level in the next few days. That would be a positive. Then you’d probably see stocks turn back down again and test the lows made earlier this week.

It’s very unlikely you’ll see a straight bounce back through the moving averages and back into happy land.

What you’ve seen over the past few weeks is a market collapse. Not a massive one…not yet anyway. But a collapse nonetheless. Panics don’t happen very often and when they do, you need to heed the warning.

What is the warning about this time? In a word, China. Over the past few days I’ve noticed a major change in mainstream opinion towards China. People are starting to question the powers of the Communist Party to engineer desired outcomes.

For Australia, it’s been an article of faith for years that China’s leaders knew what they were doing. Australian politicians and business leaders of all stripes dismissed every major problem that surfaced in China, saying that the authorities had the ‘tools’ to deal with it (ignoring the fact that their ‘tools’ were the problem).

But there is a big difference between dealing with something and simply kicking the can down the road, which is what China has been doing for years.

I’ve followed the China story closely for a long time. In 2011, I wrote a widely read report called ‘China’s Bust’ to explain the difficulties that the Middle Kingdom faced in the years ahead.

But mainstream opinion always stuck to the line that China had things under control. Despite the iron ore and commodity price crash, despite the clearly out of hand Chinese property and building boom, China, apparently, had things under control.

Not any more. Martin Wolf writes for the Financial Times. He’s one of the leading opinions makers in global economics. People read him so they know what to think. Wolf is a classic mainstream thinker, if only a more knowledgeable and sophisticated one than most.

His recent opinion piece in the FT, ‘Why worries about China make sense’, gives you a sense of how the world is starting to see China.

One must distinguish between what is worth worrying about and what is not. The decline of the Chinese stock market is in the second category. What is worth worrying about is the scale of the task confronting the Chinese authorities against their apparent inability to deal well with the bursting of a mere stock market bubble.’

That is, do China’s leaders really have everything under control? Their bungled attempt to prop up the stock market casts big doubt on that claim.

It’s one of the major reasons why the Aussie market dropped so precipitously in recent weeks. The Aussie economy is hugely dependent on China. If China is losing control, then Australia stands to lose a lot too.

So keep an eye on this story. If doubts about China’s ability to control economic outcomes continue to increase, a bounce in the stock market is all you’ll get…and then it could well head back down to new lows.


Greg Canavan

Editor, The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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