Avoid the Spread of the Stock Market "China Syndrome"

By: Money_Morning

Michael E. Lewitt writes: Stocks were sailing toward new record highs last week until they suddenly came crashing down on Friday. The shift occurred after China took steps to rein in its parabolic market by easing restrictions on short selling and raising margin requirements.

This is what happens when equity investors decide to ignore weak earnings, deteriorating economic conditions and geopolitical chaos and place all of their faith in the ability of central banks and other regulators to bail them out time after time.

The minute those authority figures disappoint them, they run for the hills. And that is exactly what happened on Friday as major stock markets around the world sold off in droves.

The China Securities Regulatory Commission and the Shanghai and Shenzhen stock exchanges together with two industry associations, took steps on Friday after markets closed, to address fears that the country's soaring stock markets could trigger a crash.

A Softening of the Chinese Bubble

The Shanghai Composite Index, home to China's biggest stocks, has doubled over the last year and surged 6.3% last week and 14% so far this month. The small company ChiNext Price Index is up 73% so far this year. Hong Kong's Hang Seng Index is up 17% so far this year. Naturally, this raised more fears than it assuaged.

Back in the States, where markets were still open after the regulators issued their warnings, the iShares China Large-Cap ETF (NYSEARCA: FXI) – a popular speculative vehicle for China bulls – plunged by 4.2% on Friday on more than twice the average volume.

Before Friday, investors figured that the continuing bad economic news out of China would lead that country's authorities to keep pouring gasoline on the fire by pumping out additional stimulus.

Recognizing that things are getting out of control, the authorities decided to speak up. Whether they back up their words with action remains to be seen. China is home to a debt bubble that dwarfs those in the rest of the planet, so Friday's warnings may only be a brief reprieve before the party resumes. Investors would be wise to steer clear of this likely crash-and-burn scenario.

For the week, the Dow Jones Industrial Average dropped 231 points or 1.3% to close back below 18,000 at 17,826.30.  It is now down on the year. The S&P 500 shed 1% or 21 points to 2081.18, bringing its year-to-date gain to a measly 1.1%. The Nasdaq Composite Index lost 64 points or 1.3% to close at 4931.18, back below the hallowed 5,000 level of the Internet Bubble.

CNBC dutifully paraded out a series of guests – some who literally looked like they were still in high school – to explain why Friday's sell-off was another buying opportunity. It is telling that the knee-jerk, robotic reaction to any notable downward move in the market is to ask whether this is a "buying opportunity" rather than looking at how investors can protect their capital in the face of lousy earnings, a lousy economy and geopolitical chaos.

That is the ugly bull market mindset at work – the mindset that leads unknowing investors to lose lots of money time after time.

Earnings So Far Fail to Impress

We are early in first quarter earnings season and low expectations are being met. Last week, American Express (NYSE: AXP) announced terrible earnings on the back of its loss of Costco's business, leading it to be the worst performing Dow component on Friday (-4.44% and down 16.9% year-to-date).

Companies like Johnson & Johnson (NYSE: JNJ) that have enormous overseas exposure reported numbers that demonstrated the impact of the strong dollar. JNJ's earnings took a 13.2% hit from currency weakness abroad, a sign of what can be expected as earnings season unfolds.

The early highlight of earnings season was Netflix (NASDAQ: NFLX), which announced earnings per share of $0.38 versus expectations of $0.63 but much higher subscriber growth than expected. This led investors to bid up its stock by $96 per share (20%) by the end of the week.  To demonstrate the bull market mind at work, NFLX was able to convince investors to ignore a $0.17 per share currency hit, which it simply included in the "other expense" line in its financial statement and added back to earnings…Accounting standards sure ain't what they used to be.

NFLX also burned $126 million of cash in the quarter as it continues to follow the Amazon model of "build it and they will come," which applies to both subscribers and shareholders. Now trading at a P/E ratio of 148, NFLX can lay claim to being a poster child for the stock market bubble along with Tesla Motors, Inc. (NASDAQ: TSLA) who will shortly announce its earnings with all of the fanfare that its chairman, Elon Musk, usually brings to such events.

Back on planet Earth, the U.S. economy continues to struggle as interest rates in Europe move deeper into negative territory. The benchmark 10-year German bond appears headed for the dubious mark as it closed the week at 0.07%. Banks in the region are now dealing with the fact that some of their mortgages are paying negative interest, which effectively means that they owe money to their borrowers.

It only takes a minute of reflection to see how insane that is – a bank lends someone money for a house, but instead of the borrower paying interest to the bank, the bank has to pay interest to the borrower! This erodes the value of the loan and, if it persists long enough, would destroy the capital base of the bank.

This scenario is starting to be played out in other venues throughout Europe where something on the order of €3 trillion of short and intermediate term (10 years and under) debt bears negative interest rates. European insurance companies, for example, carry about €3 trillion of fixed payment obligations that were made when rates were much higher and can no longer be funded profitably with rates near or below zero.

Their capital is being eroded every day as they try to meet these obligations.  In order to do so, they are being force to look outside the public markets to riskier and less liquid investments like private equity, real estate and venture capital. Similar scenarios have been playing out in Japan and will be coming to America's shores.

Reality Comes Home to Roost

When the former tenured professors that run the world's central banks cooked up their quantitative easing and zero interest rate schemes, they lacked the real world experience and knowledge to appreciate the consequences of their actions. None of them had ever sat on a trading desk or run an operating business. As a result, they were like children playing with a chemistry set.

And now they have mixed a toxic brew of chemicals that is going to set off a financial explosion the likes of which the world has never seen. Years of zero interest rates and trillions of dollars of bond purchases that are now sitting on central bank balance sheets have seriously impaired the normal functioning of markets.

They have destroyed the pricing mechanism that markets are supposed to provide and sucked most of the liquidity out of the markets that should lubricate the global economy. This renders the global financial economy far more fragile than it was eight years ago -on the cusp of the worst financial crisis since the Great Depression.

These technocrats, who are academically overeducated but undereducated in matters of practicality, thought they were strengthening the global system. Instead they were dramatically weakening it.

When the music stops, they are going to be like the organ grinder whose monkey deserted him. And the rest of us will be running around trying to find the monkey.

Source :http://moneymorning.com/2015/04/19/avoid-the-spread-of-this-china-syndrome/

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