Yesterday a 9% tumble in China’s stock market spread across the world causing the Dow to fall by 3.3% and many emerging markets to decline by even more. It is difficult to determine exactly what triggered the Chinese market sell off, but there were rumors circulating that the government will be introducing a capital gains tax.
Now its important to keep in mind that Chinese stocks have tripled since 2005. When stocks appreciate by so much in such a short time investors are looking hard to find an excuse to book profits. The rumor of a capital gains tax may have provided them with just that.
Whenever a large market such as China experiences some sort of chaos, it is reasonable to expect nervousness to spread around the world. China is an important US trading partner and US stocks fell in sympathy. Many emerging markets dropped because they are dependent on supplying China with commodities and raw materials.
The yen carry trade also played a role in causing the selling to spread beyond China. Yesterday, the yen appreciated by 2.3% amid the panic. This indicates that financial institutions that had borrowed yen to buy Chinese stocks, cut their losses by selling their stocks and buying back yen to close the trade. As the yen appreciated, others who were engaged in the carry trade were also forced to raise liquidity by selling their global stock holdings.
Yesterday, I watched CNBC for the first time in a while just to see if most of the talking heads had changed their rosy outlooks on stocks. Unfortunately, the consensus seems to be that the plunge was simply a correction and not the beginning of a bear market. As a contrarian, I feel comfortable believing that yesterday’s pain is just the tip of the iceberg.