August 23, 2015 Correction

Risk/Reward Vol. 273

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

I remain on summer sabbatical. But, the extraordinary events of the past two trading days mandate that I memorialize my impressions.

On Thursday, aspecific concerns about global growth caused a sharp decline. That decline became a rout on Friday in response to news that the Chinese manufacturing index (PMI) had fallen to its lowest level since 2009. Chinese manufacturing now is officially in a state of contraction. By their close on Friday, both the Dow Jones Industrial Average and the S&P500 had fallen 5% in two days, and each is now in a correction. (A market correction is a drop of at least 10% from a market’s high experienced in the previous 12 months.)

So why did this news from China rock our markets? Because bad news from China impacts more of the world than from anywhere else; the US included. As detailed in Vol. 74 of this venerable publication (www.riskrewardblog.blogspot.com ), Chinese industrial production single handedly supports most emerging market economies. These economies are heavily dependent upon exporting commodities. China consumes 53% of the world’s cement, 48% of its iron ore, 50% of its coal, 45% of its lead, 40-50% of its copper, 36% of its steel and a growing percentage of its oil. With Chinese production slowing, the world is in a state of commodity oversupply. Emblematic of this oversupply is crude oil, the price of which fell below $40/bbl on Friday. This is a drop of 55% from last year. Crude is at its lowest price in six years.

In 2009, when China’s PMI was last at its current depressed level, the Chinese government embarked upon a massive stimulus program; building power plants, roads and thousands of new apartments. The byproduct of this program was a resurgence of commodity prices, a boost in emerging market prosperity and steady if sluggish worldwide economic growth. China’s willingness or ability to repeat that program in 2015 is suspect. Instead, many are expecting China to engage in a currency war in which China will allow its yuan (a/k/a RMB) to devalue 25-30% against the dollar. This will make Chinese products so cheap no Western country will be able to compete. Compounding any devaluation by China is the impending rate increase promised by the Federal Reserve sometime this year; a move which will strengthen the dollar against every other currency and which will make American products even less price competitive.

With the above as a backdrop, a correction to the unprecedented six year bull market should not be a surprise. How long it will last and how deep it will go remain to be seen. As for me, I stay focused on the rate of the US Ten Year Treasury Bond which once again fell below 2.10%. The volatility it has experienced in anticipation of the Fed’s rate increase was magnified by the news from China. That volatility is why I went to cash several months ago and is why I will remain so deployed until the rate increase is announced.