Thursday, January 7, 2016

After a Second Circuit-Breaker Session, Rule Suspended

Despite a flood of government money, the Chinese stock market fell 7 percent today for the second time this week, triggering the new circuit breaker and closing trade early for the day. At the end of the day word came that regulators are suspending the market circuit breaker. Absent any word of how long the suspension will last, I assume it is for a matter of weeks.

Circuit breakers are a double-edged sword. If they are almost never triggered, they provide something of a safety net for traders. But if every trading session opens with the question, “Will we trigger the circuit breaker today?” it changes the dynamic of trading. Sellers want to sell early in the session if waiting for later means they could miss their chance. The traditional stock-trading question of up or down may give way to the question of circuit breaker or not, creating a mentality of high volatility and rapidly declining prices that can be hard to shake. That appears to be the thinking behind suspending the circuit breaker rule, but after two shortened sessions out of the first four sessions of the year, it will be hard to create a back-to-normal feeling.

There is special concern because thousands of stockholders who were restricted from selling for most of last year can now start selling. These stockholders obviously would like to sell at the current elevated levels, but risk being hauled off to jail, despite the nominal rule changes, if they try to close their position in a short time, such as a couple of weeks. They will be testing the waters to find out how much selling they can get away with. The uncertainty of the rules combined with the new selling pressure will create unusual volatility.

At the same time, the Chinese government is starting to run out of money it can use to support the stock market without triggering a broad increase in prices. Regardless of details, the central government has to balance the demands of defending China’s influential position in the world and defending the price of stocks. In the short run it probably cannot do both.

There is continued talk of a U.S. recession, with forecasts calling for a 0.2 percent decline in production hitting bottom around July, then recovering before the end of the year. As I have said before, I believe forecasters and analysts are being misled by the decline in demand for factory output, specifically, manufactured consumer goods, excluding automobiles and food. Analysts are also treating the recent 0.25 percent increase in interest rates as if it were a 3 percent increase, leading to exaggerated fears of a slowdown.

Some analysts are repeating a meme from last month, saying that China can’t be blamed for a decline in demand from U.S. consumers. I believe that message is also a mistake. Demand is a two-way street. It is based not just on the financing and desires of the buyers, but also on the relevance and quality of the products. To say the same thing in more extreme terms, if a factory is making products that no one wants to buy, is it reasonable to say that the factory is not responsible? To the extent that it is true that consumer tastes are changing, all suppliers must adapt accordingly, and there is no logic in exempting China from this rule of markets.

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