Will We See a Crash in 2016?

2016 is off to a rough start, at least for stock investors. If you are invested primarily in bonds and gold, then maybe the year ahead looks more promising than last.

On the first trading day of the year — January 4th — stocks took a tumble. The Dow was down by over 450 points at one time during the day, although it recovered somewhat. The rockiness continued into the week.

Many analysts were attributing the fall in U.S. stocks to a response to the down global markets, particularly in China. The Shanghai Composite index fell by about 7% in one day, and that was with trading halts.

The Chinese economy may end up being the big story for 2016. Stocks are in a bust phase, and they are likely being held a lot higher solely because of authoritarian rules imposed by the Chinese government.

In fact, you can’t even use the stock market in China any as any kind of measure for economic health. It is a completely rigged market. It has been severely rigged ever since the first major downturn last summer.

After the big drop on Monday, Chinese officials extended a ban on selling stocks in major companies. Investors who own more than 5% in a major company will be completely out of luck, as they are forbidden from selling and will likely be forbidden for a while.

The Chinese central bank also injected about $20 billion to prop up the Chinese stocks. At this point, you almost wonder how stocks in that country could even go down.

Again, this is a completely rigged market, so it’s difficult to know just how bad the Chinese economy really is. On top of that, we shouldn’t forget that there is still a massive real estate bubble in China that has yet to fully pop.

It is interesting to note that some Chinese investors are attempting to get at least a portion of their capital outside of the country. There are reports that some Chinese investors are bidding up real estate prices in the U.S., particularly in California. You could say that they are moving from one bubble to another.

Still, I think California real estate is a much better bet at this point than Chinese real estate or Chinese stocks. But if the investors were really smart, they might be looking at real estate in somewhere like Texas.

Don’t Blame China

If China goes into a deep recession — which is looking more and more likely — then it is certain to have its effects on the U.S. economy. We can already see that just by the move in stocks this past week.

There are reasons to worry about China, as it is now a major global player and major trading partner. Ironically, though, it could end up leading to even cheaper labor in China and cheaper prices for Chinese-made products. In this aspect, it could actually benefit American consumers in the short term.

If China goes into recession and the U.S. follows suit, it is important not to place too much blame on China. It would be letting our own politicians and central bankers off the hook. In fact, that is why you will hear some politicians and central bankers attempt to explain a weaker U.S. economy by blaming China.

The U.S. is still the leading economic player in the world, despite our problems. There have been many times in recent history where parts of Europe or Japan were suffering economically and Americans barely noticed.

While a few bad days for stocks does not tell us anything significant or give us a trend, we should be cautious about what is ahead. And if there is a significant downturn in the economy, we don’t have to look at China for answers.

Unfortunately, many people will blame the Federal Reserve, but for all of the wrong reasons. The Keynesians will say the Fed raised interest rates too soon. In other words, keeping rates near zero for seven years just wasn’t long enough.

A recession should largely be blamed on the Fed, but only because of its prior policies of loose money and low interest rates. The Fed approximately quintupled the adjusted monetary base from 2008 to October 2014 when QE3 ended. While this did not result in significant consumer price inflation (don’t count health insurance), it did cause resources to be misallocated. It caused bubble activity.

We can never be absolutely certain about where the bubbles are, but stocks and California real estate, as mentioned above, definitely seem to be the top contenders. The bubble in oil has already popped.

Bubbles Go Bust

When asset bubbles form because of artificial stimulus, they usually pop. The artificial stimulus is easy money and low interest rates, but we can’t discount government policies that distort markets as well. For example, in California, real estate prices may be driven up higher than in other areas due to land restrictions and more complex building codes. These are not the only reasons, but they do play a role.

When resources are directed into a sector that would not otherwise have received this capital based on consumer demand in a true free market, then the misallocation will be exposed at some point. This means the bubble will pop.

The bubble becomes evident when the artificial stimulus dries up. In our case, the Fed stopped its quantitative easing (money creation) in October 2014. There is always a time lag for things to hit.

This doesn’t mean a stock market crash has to occur in the near future. Sometimes things take a while to play out in a huge economy. And there are still some people and companies out there with savings available to invest to keep things going for a while.

Another factor is the massive excess reserves piled up by the banks. Much of the new money created by the Fed from 2008 to 2014 went into bank reserves instead of being lent out. If the banks were to decide to start lending out just a fraction of this money, it could keep the stock party going for a while longer. The stock party started in 2009 when almost nobody wanted to touch stocks.

Still, the chances of banks increasing lending at this point are low. First, people do not want to go into more debt, even at low rates. There are always some who will, but on the margin, low rates are not attracting more borrowers at this point.

Second, the Fed just hiked the federal funds rate by a quarter point. In order to achieve this, it is now paying banks 0.5% on their reserves. In other words, the Fed is paying the banks not to lend. Therefore, banks are not going to lend out as much money when they can get a guaranteed safe return from the Fed. If anything, they will likely tighten their lending standards.

This is pointing to a likely deflation of the stock bubble, assuming there is one. It may deflate slowly, or it may pop more suddenly.

Balancing Your Portfolio

Investors do not usually want to hear bearish news. But I have to keep it realistic here and call it as it stands.

This isn’t to say you should sell all of your stocks immediately. But if you are heavy in stocks and this commentary makes you nervous, then you should think about diversifying and sleeping better at night.

Even in the worst bear markets, there are a few stocks that still go up. So if you have a short list of stocks that you like, you should keep them. A new year is a good time to do an assessment of your portfolio anyway.

Meanwhile, you should have a relatively strong cash position right now. Cash is king in an economic downturn, not just because it generally holds its value, but also because you can use it to buy bargains when things are down.

And as much as I don’t like government bonds, investors see them as a form of safety. Despite the Fed raising rates, long-term rates could easily fall if stocks continue to go down.

As for gold, it is not typically the best investment to own in an economic downturn where there is relatively low price inflation. Still, I always recommend at least 15% in gold and gold-related investments as a hedge and further diversification. Gold will shine again when the Fed starts printing money again.

We can’t say for sure if a stock crash is ahead in 2016. But the first few trading days of the year should make you think. You don’t have to ask if it is going to happen. Instead, ask yourself if you are prepared in case it does happen.

Until next time,

Geoffrey Pike for Wealth Daily