A note from Rob:
Long time readers of OfWealth will know that we think US stocks are both richly priced and at risk of big falls.
When? Who knows. But with high levels of leverage embedded in the market – both at the company and investor levels – the risks are magnified.
A stock market implosion on the other side of the world, in China’s domestic A-share market, is a reminder of the risks elsewhere.
Today’s special guest essay takes a look at that, and what it could mean in the US and other expensive and leveraged markets.
So now I’ll turn things over to our friend Eric Fry at the Non-dollar report. Enjoy.
When $4 Trillion goes to stock market heaven
Not to be alarmist, but the wealth destruction taking place in China is truly alarming… and it is probably not a “non-event” for the U.S. financial markets.
During the last 30 days, nearly $4 trillion of Chinese stock market wealth has gone “Poof!” That’s a very large number. It is larger, for example, than the market value of every stock in the United Kingdom.
Losing $4 trillion of stock market wealth, therefore, would be like every stock on the London Stock Exchange falling to zero! … Or it would be like every stock on the French and German stock exchanges falling to zero… Or like every stock that trades in India, Australia and Brazil falling to zero.
$4 trillion is a big number, folks.
In fact, it is larger than the $3.7 trillion of foreign exchange reserves the Chinese have sweated to accumulate during the last two decades. That kind of money doesn’t come easily. But apparently it vanishes quite easily.
Perhaps $4 trillion of Chinese wealth can go to stock market heaven without sending any serious shockwaves throughout the rest of the world’s financial markets. After all, this capital was mostly “phantom wealth” anyway. It did not exist before last March, when the Chinese stock markets started to “go parabolic.” So maybe the world’s financial markets will be able to forge ahead as if this $4 trillion boom and bust never really happened.
But that’s not usually what happens in the aftermath of a big financial bust. Usually, knock-on effects pop up in lots of different places… and in lots of different financial markets. And that’s because big financial busts usually force leveraged investors to deleverage – i.e., to sell assets.
Deleveraging usually begins with the good old-fashioned “margin call.” (This process is already unfolding in China.) Leveraged speculators sell stocks to raise cash to cover their rapidly increasing losses. As the losses grow, the speculators sell other assets in order to raise cash. Those assets could be anything from bonds to gold to, yes, even U.S. stocks.
But these margin calls are merely the beginning of the deleveraging process. After all, China does not possess a monopoly on leveraged speculators. These folks are everywhere… and in every financial market.
So when one big market loses a quick $4 trillion, many of the leveraged speculators operating in other financial markets go into “risk off” mode. They reduce their leveraged bets, wherever those bets may be… including, potentially, leveraged bets on U.S. stocks. And remember, U.S. margin debt sits at an all-time high.
On top of this traditional leverage sits an even larger pile of leveraged derivative instruments. When you add it all up, there’s quite a bit of leverage out there that could be unwound.
So if a few leveraged speculators start taking risk off, stocks might start dropping a little… which could inspire leveraged speculators to take more risk off… which could cause stocks to drop a little more.
Before long, ordinary folks might also head for the exits and, voilà, you’d get a stock market sell-off. Nothing that’s automatically catastrophic, mind you, just something that features minus signs instead of plus signs.
A China-induced sell-off in the U.S. stocks is not a certainty, of course. The U.S. stock market may well remain the oasis of calm and continuously rising prices it has been for most of the last six years. But that delightful outcome seems unlikely.
Great big financial market busts do not usually “go gentle into that good night.” They usually go wildly into bad days of volatile trading.
Bottom line: There may be no reason to panic… but if you’re in a mood to panic, now might be a good time to do it.
P.S. If you enjoyed today’s issue, please check out Non-dollar report to find similar insights from Eric Fry.