Different Take On China

 |  Includes: DIA, FXI, GXC, PGJ, QQQ, SPY
by: Financial Sense

By Thomas J Smith

Several years ago I worked with a gentleman who spoke with a thick and unforgettable southern drawl. When there was a run in some smaller growth stocks for some time, his one-word answer was usually: China. Whenever someone talks about the impact of China on the markets, I still hear a thick South Carolina draw.

In the first decade of the new century, China ramped up everything in a big way. At the beginning of the 2000s, roughly 10% of U.S. companies talked about China. Today, more than half of the S&P 500 companies talk about China in quarterly reports. This boom in Chinese investments created a favorable environment for all things emerging. This created a new place for aggressive investors to allocate capital after the decline in tech stocks. This created higher correlations in the market as the impact of China's growth was felt across sectors and countries.

This boom in Chinese growth had a profound impact on commodity prices. They were the marginal buyer of all commodities, which created a decade long run in this space and also helped fuel a prolonged period of global inflation. The sustained increase in input costs hurt profit margins and caused a decade long contraction in P/E ratios. Simply put, if costs are rising and profits are coming down investors are not going to pay up for earnings.

Today, investments in China make up close to 50% of its GDP. That rate is unsustainable. As China goes through the long and slow process of spending less on infrastructure and raw materials and more on domestic-led consumption, the demand for many commodities will decrease.

This decrease in pressure on commodity prices helps all industries here in the U.S. This creates a tailwind to Leading Economic Indicators (LEIs) and increases our growth rates. Declining commodity prices will act as a tax cut or pay raise for the consumer. With the consumer making up 70% of our economy, an improving consumer helps the market. The sustained rise in commodity prices in the 2000s cut into discretionary spending. That trend will reverse as China's investments decline.

As the consumer spends less in the form of price inflation, U.S. companies will operate in a much better environment. The consumer tax cut, in the form of lower commodity prices, leads to more discretionary spending. This trend increases earnings visibility for many companies.

With margins expanding and analysts more confident in their earnings projections, P/E ratios can expand. People often place 100% of their focus on the last battle. The 2000s were so tough people do not feel comfortable with expanding P/E ratios. Many were very leery about expanding P/Es last year. A big reason for that is that many can't remember a time when P/Es were expanding. Certainly P/E ratios are higher than where they were in 2009. But, that was the last "death of equities" period we went through. It is not surprising that P/E levels are above those depressed levels.

Certainly P/E ratios are important. We are seeing the importance of reasonable valuation levels playing out in the market right now. Many of the speculative areas of the market that had seen valuations skyrocket have seen severe selling over the past few months. But, there are still several areas of the market where valuations are quite reasonable. The cycle for expanding or contracting price earnings ratios typically lasts for a decade. We have seen valuations rise, from depressed levels, for two years.

The technical condition of the markets tells a tale of two cities. Large-cap issues with reasonable valuations remain in favor. The speculative areas of the market remain under pressure. Large-cap names with increasing dividends and a predictable earnings stream are the leaders. The latest flurry of high flying IPOs has led to a decrease in demand for the speculative areas of the market.

On a technical basis the Dow and S&P 500 are in better shape than the small-cap averages. The debate rages on regarding if large caps will be dragged down by the small caps or if smaller stocks will rebound. Here are some levels of interest for the major averages to help guide us in navigating these treacherous markets. For the smaller cap Nasdaq and Russell 2000, resistance levels are 4,180 and 1,140. Resistance for the S&P 500 and Dow are 1,898 and 16,633, respectively. Support for the Nasdaq and Russell are 3,990 and 1,090. Support for the S&P 500 and Dow are 1,858 and 16,300.