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"Black Death" Stock Markets. How China Sees the Future

|Includes: AAPL, NFLX, Sanofi (SNY)
What on earth is going on with the stock markets? That's certainly the most-asked question of the month. The only thing more plentiful than questions is a surplus of inconclusive answers.

There really is no precedent for the kind of trading we have seen in the past two weeks. Like a runaway rollercoaster the Dow Jones Index has plummeted by 500 or more points in a single day, only to bounce back by almost as much the next. And, of course, the following day the Index dives yet again by hundreds of points.

High volatility is often blamed on machine trading. But hedge-fund computers have been engaged in high-frequency trading for years without creating the extreme day-to-day volatility we have seen this month. That's not the full explanation.

Dow Jones Index Two-Week Performance

china stocks,chinese economy,chinese stocks,china economy,china stock,china stock digest,global profits alert,jim trippon

Credit: Google Finance

The Standard & Poor's downgrade of U.S. debt on August 5th has also been blamed for market weakness. That certainly has to be a factor, but as you see on the chart above, U.S. markets actually rose sharply on the morning after the S&P downgrade.

Europe's debt problems are another obvious target for blame. They are serious and complex issues, but concerns about European finances have been troubling us for almost two years.

The most dramatically negative description of Europe surprisingly comes from the China's top official newspaper, the People's Daily. It commented, "The euro debt crisis…and the sovereign debt crisis has spread like the Black Death of the fourteenth century across the euro zone countries".

Now those are harsh words coming from a government organ.

Piling on all the negative pressure is a weak economic growth outlook among developed nations. The latest GDP figures from Europe shows that even the engine of the continent, Germany is slumping dangerously close to zero or even negative growth.

China's stock markets are also pricing in western weakness with the Shanghai Composite Index slumping to lows approaching the 2500 mark. Despite strong ongoing predictions for Chinese expansion, fears of a slump in western export markets have depressed even Chinese investors.

What's remarkable about all of these factors is that they are all negatives. Combined, these negative forces should be pushing to market down steadily and relentlessly. But that's not exactly what's happening.

Instead we see manic market gyrations. Death defying plunges are followed by breathtaking upturns. If all of the news is bad, then why is the market bouncing so wildly?

Magic Bullet?

We may hear nothing but negative news from the mainstream media, but the reality is far more complicated.

Did anyone among the major networks notice that the vice-president, Joe Biden made a pilgrimage to Beijing just after the S&P downgraded U.S. debt? If they noticed, they didn't tell anyone.

Sources who did report on Biden's trip said he was on a mission to reassure America's bankers about the safety of U.S. debt instruments. Not so. Here are Biden's own words, recorded aboard Air Force Two: "I didn't sense it a bit that they needed reassurance about our economic stability or well-being. I didn't get any sense that there was any anxiety on the part of the Chinese government about whether or not we were a rising or declining economic power. I got the sense that, just like with us, they were hoping we'd begin to grow again seriously -- because it's in their interest."

What about Europe? Despite the Black Death headline, China holds far less of its reserves in euros than it does in the dollar. But China is anxious that an endless spiral of financial crises in Europe will weaken the buying power of the continental economy (which has a bigger GDP than the U.S.). President Hu Jintao will meet French president Sarkozy this week and you can be sure that he will once again take a very public stance in support of a strong euro.

The point I am making is that there are many positives in global economics and in corporate profits. That's why markets are displaying such a split personality.

Great companies have sunk to fire sale prices on American and European exchanges. That's a key source of buying pressure. Whether it be Sanofi-Aventis (NYSE:SNY) in France or Apple (NASDAQ:AAPL) in the U.S., the picture is the same. Earnings and earnings growth are excellent. But corporate valuation is still at bargain basement levels.

Is there any magic bullet to beat the markets? Not today. Here's an experiment to show you why.

Six-Month Performance Comparison, Netflix, Apple, P&G

Netflix-Orange, Apple-Green, P&G-Yellow

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Credit: Bloomberg

I charted these three companies because they are so different. Netflix (NASDAQ:NFLX) is an ultra-high fast growth company with a high-flying P/E multiple. Apple is a global growth company with a relatively modest P/E. Proctor & Gamble is a relatively stable consumer products company with a reliable dividend.

As you can see, investments in all of these divergent companies would have performed differently over the past six months. P&G would have moved relatively little compared to the wild ride that Netflix gave its investors. Apple stock enjoyed a brief growth spurt, but all three finished in more or less the same spot where they started.

I couldn't explain it any better than the legendary Abby Joseph Cohen. Goldman Sachs' market guru told CNBC that the market is now pricing in a recession, even though she believes it is an unlikely event. In her words: "Let's be very clear, there are some fundamental worries but our feeling is the valuation of the U.S. stock market is already pricing in a rather ugly scenario…many years of no earnings growth…not the most likely scenario."

In short, stocks are too cheap. That is why we sometimes experience very sharp upward movements.

The market's recent erratic behavior shows at least some investors also believe that the market is underpriced. I do expect we will see some dramatic stock moves as the global pandemic of fear finally lifts. How soon that will happen is still anyone's guess.

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