The recent weakness in stock prices and relatively depressed sentiment measures left the market likely for a bounce. The American Association of Individual Investors latest survey, for example, showed twice as many bearish investors as bullish.
Beyond a short-term bounce, however, there is an area of potential vulnerability that has implications for all risk assets--China. China’s booming economic growth and voracious demand for all manner of “stuff” have driven commodity prices sharply higher, and has fostered—along with the Fed’s Ben Bernanke’s clear focus on spurring higher stock prices—an environment of widespread speculation. A setback in China’s rampant growth would have a big impact on the speculative environment. Such a setback could well occur. Despite recent curbs on bank lending, there already are large concealed losses in China’s banking system.
Furthermore, fixed investment now accounts for nearly 50% of Chinese GDP. Historically, when a country’s fixed investment comprises 30-40% of GDP, the result is usually substantial excess capacity that is followed by sharp production cutbacks. With China now the world’s second-largest economy and the U.S., U.K., and Japan struggling, a break in China could make the “risk trade” seem less like a sure thing and further increase the appeal of large-capitalization stocks that have strong cash flows and above-average dividend yields. Keeping some cash on hand for better buying opportunities seems advisable.
S & P 500: 1288