Saturday 10 December 2016

Investors should be in no doubt - there's still plenty of time to panic

This crash is not just a China story - and if you are under that impression you are missing the big picture

Paul Sommerville

Published 30/08/2015 | 02:30

The Sommerville position on July 12
The Sommerville position on July 12

Global markets last week suffered a trauma, a seizure, a heart attack.

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After precipitous selling the previous week (DAX down 7pc, S+P down 6pc, and Shanghai down 11pc) the markets were expecting some intervention from Chinese authorities over the weekend.

When that did not arrive the selling began in earnest. The Chinese market fell another 9pc, the European markets fell in sympathy - and then when the US markets opened, all hell broke loose.

The Dow Jones fell over 1,000 points in the first minutes of trading. The price action on Tuesday was in some ways even more extraordinary with a multitude of wild swings, gut-wrenching drops and huge volume selling pressure not seen in many years.

The German Dax closed down 22pc from its recent high, the Shanghai index, up a stunning 60pc earlier in the year, gave back all those gains and more. Both the Dow and the S+P 500 fell into 'correction' territory (which is defined as falling over 10pc from recent highs, the S+P having the largest six-day decline since October 2008).

Then, later in the week, an almighty bounce ensued. In short, it was utter chaos.

World media immediately reported China and falling commodity prices to be the cause. But this is not a China story and if you are under that impression, you are missing the big picture. China may be a catalyst but the causes lie elsewhere.

The fact the Chinese economy is slowing is a surprise to nobody in financial markets. We have noted previously in this column that the 7pc GDP reported is likely a figment of the imagination. Likewise commodity prices have been falling consistently for over five years.

This is a story about credibility of central banks and the fragility of the entire financial system. Above all, it is a story of the inevitable consequences when the fragility of an artificially manipulated financial system is finally exposed.

We saw only a brief glimpse last week. There is likely much more to follow.

For six years, the central banks have propagated the illusion they are firmly in control of the financial system. They have created a worldwide bubble in financial assets of all kinds. They have bastardised the financial system and done away with the prime function of financial markets - price discovery. They have injected a tsunami of liquidity and permitted the cancerous belief that they will prop up assets of all kinds at any cost.

Above all, they have created a false stability and excessive risk-taking. It has produced the most profound complacency.

The credibility of the Federal Reserve is now on trial. It is not only China that is slowing, but also the US economy; contrary to common perception, is looking increasingly fragile. It is reported that markets are concerned that the Federal Reserve may increase rates by one quarter of a per cent at its upcoming meeting in September - but that is not the case.

The markets are petrified that the Federal Reserve believes the economy to be so weak that it cannot handle the most modest of rate increases. Extreme stock valuations, lopsided bullish sentiment and compressed risk premiums - when mixed with a possible global growth correction - are a potentially explosive cocktail. Couple that with the nagging feeling that if global growth is going to slow, every central bank is out of bullets, and you get price action like we saw last week.

So what should investors do?

Regular readers will know that in our last column in July we advocated to trade 'short' the S+P 500. That turned out to be very valuable advice.We would consider after the inevitable bounce this is a valid strategy for high-risk, experienced traders to look at again. We do not believe the selling is over.

For long-term investors, we continue to advocate that you should be using any subsequent bounces in equities to lower exposure. For those wanting to allocate more resources to the stock markets, we believe you should wait, looking for lower entry points.

For those with a more rosy outlook and more faith in central bankers than I have, a valid strategy may be to buy European equities at lower levels. The reason we suggest Europe over USA is that if the situation deteriorates, the ECB is the most likely to unleash additional monetary stimulus.

More short-term/medium-term investors have plenty of opportunities in this market. Remember, great bull markets do not die overnight. The snapback rallies where bulls are still supremely confident are powerful and violent. We, for example, are expecting a short-term bounce in energy related companies.

Above all, investors will be bombarded with financial salesmen and pundits declaring there is nothing to worry about. Economists (the absolute worst people to take investment advice from) will explain that trade with China is small and thus irrelevant. Nearly all will agree that the markets are sometimes irrational or beyond comprehension and best ignored. But the fear we all saw last week was entirely rational - it was the utter complacency that preceded it that now seems irrational.

A light bulb went off with professional traders that perhaps the financial world created by the Federal Reserve is an illusion.

Some referred to the price action of last Monday as 'Black Monday'. It was nowhere near - but many forget that the real Black Monday did not happen in isolation. There were many precipitous falls in the weeks leading up it which foreshadowed the actual 1987 crash.

The markets screamed a very loud wake-up call to investors last week. It is better to listen to what the market is telling you than those 'explaining' the market.

If you can keep your head when all around are losing theirs, it is possible you don't understand the enormity of the situation.

Paul Sommerville of Sommerville Advisory Markets is contactable at paul.sommerville@sam.ie

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