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Stock Market Chaos: A Correction or a Bear?

As stock markets opened around the world last Friday, there was no doubt about who was steering the ship. A plunge of more than five percent in the Shanghai Composite Index echoed around the globe. Stock markets from Australia to New York followed China's lead and took a plunge.

The drop in Shanghai was the worst I've seen since the summer of last year when Chinese stocks appeared to be in free fall. This year was different. The Shanghai Index had risen more than 33 percent since July making it one of the world's best performing markets. Was it profit-taking as some commentators said? Or, was it a more serious turn in market direction?

Stock Market Chaos: A Correction or a Bear?

As the S&P and NASDAQ followed China's lead, breathless experts explained it this way. Chinese inflation figures had come in too high at 4.4 percent. Markets were reacting with fear to the prospect that Beijing might raise interest rates and slow down the world-leading Chinese economy.

Nice in theory. But the talking heads missed some key facts. China's worrisome inflation numbers had come out two days before the Shanghai plunge. Stock markets never react to key data that slowly.

As for tightening, Beijing had already taken care of that. The day before releasing the inflation numbers, bank reserve ratios were jacked up by a hefty 50 percent. That was no coincidence. China's central bankers were moving to shore up banking reserves and soak up money before that inflation news was released.

One American TV personality, famous for his "Mad Money", predicted that Beijing would raise interest rates again over the weekend. If so, that would cause further market declines around the world.

From my experience, I would say Beijing is unlikely to provide more shocks to the system in the immediate future. The Chinese government has always been eager to quell stock market turbulence. Putting more brakes on the Chinese economy would alarm investors even further.

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By raising interest rates and reserve ratios before the surprise inflation figures, Beijing gave the appearance of being in control of the situation. Imagine if you will the impression that global investors would have had if the central government rushed to make major monetary moves in reaction to high inflation. It would have seemed like a panicky, open-ended effort to regain control.

Retreat on All Fronts

The U.S. reacted to Shanghai's plunge with unusual alarm. Every sector of the stock market fell back. No asset class was safe. Commodities fell the most in 18 months on speculation that China's money tightening would erode demand for energy, crops and metals.

Bond prices fell, sending interest rates higher. The yield on the benchmark 10-year Treasury note, which moves in the opposite direction of its price, rose to 2.70 percent.

It seemed like a landslide. The dollar resumed its decline against other major currencies. Even gold fell back below the $1400 per ounce mark. Usually the dollar and gold move in opposite directions.

Oil prices slumped more than three percent. Again, analysts blamed the fear of a Chinese crackdown on inflation, even though demand is high and China is experiencing a serious shortage of diesel.

Remarkably, the U.S. is currently getting what it wants from China. The yuan continues to rise in value, hitting a 17-year high of 6.6173 against the dollar.

The Source of Uncertainty

With a retreat on so many investment fronts on Friday, it's impossible to discern a single clear trend. Certainly not in one day's trading.

What does stand out is the general sense of anxiety. The November elections in the U.S. have yet to show if America will take any action at all against its unsustainable deficits. The future of the Bush tax cuts is unclear.

Looking further afield, there is new unease about the eurozone as the Irish financial crisis continues.

And, at the top of the heap is the failed G-20 summit. The G-20 joint statement was intended to signal progress. It didn't.

Here's a key quote: "uneven growth and widening imbalances are fueling the temptation to diverge from global solutions into uncoordinated action…uncoordinated policy actions will only lead to worse outcomes for all."

Translation: A currency war could break out.

Sure, the G-20 leaders agreed to try to prevent that. But the U.S. plan to dump $600 billion worth of the new money into the economy suggests that America is saying one thing and doing another.

Meanwhile, President Obama issued a weak warning to China, saying: "Countries with large surpluses must shift away from depending on exports. No nation must assume the road to prosperity depends on exports to the US." That followed Obama's complete failure to wring a balanced trade deal out of Korea.

Obama leaves Asia with nothing but a cloud of uncertainty and weakness over his head. To the extent that the U.S. still leads global finances, that sense of unease is infectious among investors.

Already, Fox News is warning about a "trade war".

What's Next?

The outcome of global talks has been worse than nothing. The spreading sense of unease makes all investments very volatile.

The $600 billion U.S. monetary injection has increased China's fears of a flood of new money creating more inflation. Bank of America Merrill Lynch China economist Lu Ting says he expects China's central bank to raise lending rates three more times before the end of 2011, in addition to increasing banks' reserve ratio requirements by 1 to 1.5 percentage points, and allowing a 5% appreciation in the yuan. Harsh medicine indeed.

On the other hand, Chinese stocks are becoming cheaper on a valuation basis. HSBC says Chinese equities have now become a "buying opportunity".

The Shanghai Index remains down nine percent for the year. Companies in the Shanghai Composite Index are valued at 19.2 times reported earnings, compared with 26.4 times at the beginning of the year, according to Bloomberg.

China's undervalued stocks are likely to lead the world's markets out of their latest slump. China's booming economy has made them very inexpensive.

But don't expect a bounce-back first thing Monday morning. There is too much global uncertainty to hope for immediate recovery.

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