China Remains A Ticking Time Bomb

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Includes: CNY, CYB, FCA, FXI
by: Orange Peel Investments

Summary

Chinese markets started off 2016 on edge, as the Shanghai Composite lost 7% on Monday.

Trading on Tuesday was shaky and the Chinese markets, propped up by the government, finished with much smaller declines.

US equity futures still look on edge Tuesday, and we still think the worst is yet to come.

By Scott Tzu

China downIt appears that China has averted disaster for at least another 12 hours or so, as Chinese markets went on a roller coaster ride last night, only to finish near unchanged. The unease and sentiment, however, was clearly still palpable as European exchanges and US equity futures are all in red territory.

(Tuesday morning equity & commodity futures, courtesy of FinViz -

Yesterday, we saw the US markets fall about 2% after Shanghai closed down 7% after trading was halted for the day. This raised a lot of questions about whether not 2016 could see a continuation of the unease that plagued the street in 2015 after Chinese markets crashed the first time. This is a look at what the Shanghai composite did over the last year versus what US equity markets did; and how they have both now met in similar territory, even after China's spike.

^SSEA Chart

^SSEA data by YCharts

While the damage is clearly not as bad for us as it was for China, you can see that the Shanghai's incredible move higher and fall did have an effect on US markets, before China steadied itself at lower prices and the US market eventually tried to recover. What we saw on the US equity recovery was our market try to once again break through its all time high is that it had made earlier in 2015, but our market was unable to do so. The global economic picture appears to have changed enough for the US to have lost its momentum.

Aside from that, US markets basically wrote off China's slump as a one time event and nobody really paid attention to it after US markets continued to rally. We think this is a mistake, and we think yesterday's trading, showing increased volatility in the Chinese market, will become more common.

Once again to address unease in the Chinese markets, it was reported last night that the Chinese government was injecting about $20 billion into the market and that the Chinese central bank was supporting the Yuan.

These measures are being taken after preventative measures placed in mid 2015 are starting to expire. When the market crashed the first time in 2015, China made it so that 5% holders could not sell their stakes in companies and that those selling were cast in a extraordinarily unfavorable light.

Those may have been the only band-aids that were keeping China's market healthy over the course of the last six months or so. Now that those regulations are set to wear off, China has begun crashing again. Many reports out Monday morning cited the removal of these restrictions as a reason for the decline in stock prices.

What is happening now that these restrictions are wearing off?

China is getting ready to lay on a whole new set of band-aids.

We know where this is going to lead the country. You cannot keep applying band-aids to a problem that is getting worse and hope that it eventually goes away. At some point, The bigger the band-aid you place, the worse the turmoil is going to become in the long run.

China should have just let its market collapse, because even though the carnage would have been worse, it would have likely already come and gone. "Acting as if everything is OK when it is not" is not a good strategy when it comes to equity markets. The markets will eventually correct and eventually price things according to their absolute value.

Continuing to try and prop up the market is a terrible role for the government to have.

We have enough issues in the US with the Federal Reserve and their inconsistency. In China, the problem is much worse. Not only do you have a government that basically can do whatever they want when it comes to the stock market, but you have macro economic data and numbers coming out of China that we don't even know if we can trust. When we get something like a PMI number that causes the markets to crash, how do we know that this number wasn't actually much worse? We think we have objective data, we think we have third-party data, but nothing would surprise us out of China at this time.

It is because of this that we do not recommend investing in any US equities that have ties to China including the larger ones, like Alibaba (NYSE:BABA). If China starts to fall, we will see a ripple effect in the US, but these types of companies will be the first to show major vulnerability.

It is from this line of thinking that we believe China's situation is going to get far worse than it has been. In turn, we believe this will eventually pull down US equity markets in the global economy as well. We have not been decisive in stating that our expectations are for the Dow to have a 15 handle by the end of 2016. We think slowing global growth, especially from China, will help make our predictions come to fruition.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.