US Equities Stumble

The S&P500 lost 2.2% last week, which was one of the biggest weekly losses of the year.  Not since the early winter months has the S&P lost more, in percentage terms. Volume jumped, which as always suggests that many investors were really leaving the stock market party.  Volatility also climbed, but the VIX never reached anything remotely close to panic levels.

The technical picture is interesting in that the S&P has essentially round-tripped since early July when it stopped falling at the 200 day moving average. Then it shot back up in mid-July, back to all-time highs, but it then fell back down and is now approaching the 200 day moving average once again. In the past three years, when the methodical and seemingly inevitable staircase climb occurred, the S&P went on to set clear new highs over a period of several months before retreating back to the 50 day moving average.  This time, the S&P retreated far sooner and from far lower price levels. So some technicians will consider this failure to set new highs as a failed test, and will worry that there may be more substantial downside pressure before the index can resume its climb.

On Main Street, it was a light week for economic news releases. Existing home sales, initial jobless claims and the Chicago Fed National Activity Index all beat expectations. On the other hand, the Kansas City Fed Manufacturing Survey and new home sales both missed. In the upcoming week, we’ll see a much larger—and more normal—volume of economic reports.

Why did the US equity markets sell off?  Well it seems that the carnage in commodities, combined with the meltdown in Chinese equities, was the immediate catalyst. Remember, US stocks—by a vast number of historically proven (eg. market cap to GDP) measures of valuation—are extremely over valued. Using these measures, US stocks were more over valued only once in the last 100 years and that was just before the tech bubble burst in early 2000. The point is that any near-term catalyst can trigger an avalanche caused at root by over valuation, so the specific trigger is less important to causing stock market losses than valuation.

In this case, China’s stock market after almost tripling in about a year, has fallen by about 30% in a matter of weeks; this, as most market observers would agree, is a crash. And what’s more troubling is that the Chinese government is throwing everything including the kitchen sink at the sell-off without much success. Shockingly, the government has made some forms of selling, by certain major market participants illegal. And to add insult to injury, the government has resorted to simply shutting down its stock markets when everything else fails.

But around the world, this is sending shock waves to other financial markets. For one, financial losses in China’s markets can be hedged by selling in other less manipulated and restricted markets. So if you can’t sell in China, you may try to reduce risk by selling something comparable in US or European markets. Thus Chinese selling begets selling around the world. Secondly, the Chinese stock market crash is sending a signal that the Chinese economy is slowing and the last time it did so was in late 2007.  The point being that about 6-12 months later, other markets around the world also crashed. China’s markets, and even economy, therefore, could be providing an early warning signal of what’s to come for the rest of the world. And if so, it’s not going to be pretty.

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