You’re going to hear all sorts of reasons why China’s ongoing stock market collapse doesn’t matter to Western investors.
Their mainland stock market is closed to foreign investors. They were sitting on bubbles and everyone knew it. They were highly leveraged.
All of these things are true, but they should be dragon-like warnings to investors everywhere — or should I say black swan alerts?
The reason why the Chinese market crash is threatening is for reasons you can’t measure. As John Maynard Keynes said in the 1930s, it’s the “animal spirits” you can’t gauge.
What are animal spirits? Irrational exuberance. Unbridled optimism. The belief that you should borrow to the hilt to buy stocks because there’s no tomorrow.
We’ve seen this herd run over a cliff before: the 1920s, 1999, 2007. Almost routinely, all the usual experts are telling us that stocks are not overpriced at the time and there’s room to grow.
But you need to look at the evidence to see what classic behaviors trigger market crashes. Here are some observations from Michael Zhuang of MZ Capital Management in Washington, DC.
The stock market crash there just vaporized $ 3 trillion worth of investor wealth, all within a month. 99% of those investors are domestic Chinese investors.
According to a Goldman Sachs research, Chinese investors are highly leveraged. By some estimate, a 30% loss in market index could translate into a 60% loss to the average investor.
The growth engine for the Chinese economy is domestic consumption, not export or investment any more. Domestic consumption has been growing 10% a year in the past few years, you bet it’s going to be affected by the market crash.
There are 90 million stock investors in China, larger than the entire communist party membership.
Chinese investors are panicking, fearful, resentful, restless. As they have been conditioned to believe in the party, now they are blaming the party for their losses.
The specter of massive single issue social unrest can not be ruled out. China is the second largest economy in the world, and the biggest growth engine, should a massive unrest breakout, the effect will reverberate across the Pacific.
Before the recent 30% tumble, the Chinese market has gone up 150%. Even after this massive tumble, it’s still up about 70% from a year ago. So maybe not all investors lost money.
The Chinese stock market, like its internet, is walled in. Foreign investors can only invest in Chinese shares in the Hong Kong market, which is much more mature and stable. This has the effect of containing the economic disaster within China.
“In summary,” Zhuang concludes, “the situation in China bears close watching. The economic impact on us is limited, but fear can not be walled in, fear could spread to other Asian markets and even to our shores. Should that happen, remember what FDR said: “The only thing to fear is fear itself.”
When it comes to the contagion of fear in the markets, there are no international border police. The next market rout will move at the speed of light around the globe.
Maybe the real fear trigger will start in Athens, Brussels or the futures markets in Chicago. You need to be prepared.
What You Can Do
If you’re working with an adviser, ask for a simple portfolio review. How much is your portfolio exposed to Asian and European stocks?
Do you have an uncomfortable allocation to stocks in general?
Ask for a “stress test,” meaning how many actual dollars you could lose — and what it will mean to your lifestyle — if you portfolio loses 20% or more of its value. This is essential if you’re in or nearing retirement.
Are you self-managing your portfolio?
Then pay attention to your stock to bond ratio. A reasonably sober safety measure is to match the percentage of bonds you hold to your age.
If you’re 50, for example, you should have about half your portfolio in bonds. While this is no guarantee of preserving all of your money, it will provide a better cushion than if you’re 80% to 100% in stocks.
Another worthwhile gauge is the Shiller P/E or “CAPE” Ratio, which is above its historical average now.
This measure, developed by Yale Professor Robert Shiller, a 2013 Nobel Prize winner and author of Irrational Exuberance, shows relative values of stocks for the past 100 years.
Right now, the Shiller P/E is around 26. How does that compare?
On Black Tuesday in the fall of 1929, the P/E was at 30.
On Black Monday in late 1987, the measure was at 16.
In late 1999, just before the dot.com crash, the gauge was at 44.
And in late 2008, the ratio was at 26.
Does the Shiller ratio have any predictive value?
Since it looks backward at when stocks were known to be wildly overvalued, that’s likely, although no one knows when the rest of the market will react to that realization.
It would be convenient and profitable if there was a reliable signal that would tell you the right day to sell and get back into stocks, but that measure hasn’t been invented yet.
In the interim, look at how much you can stand to lose in real dollars. It’s not a Chinese puzzle; it should be pretty straightforward.
John Wasik is the author of “Keynes’s Way to Wealth” and 13 other books. He writes and speaks about investing across the globe. Follow him on Twitter and Facebook.