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China is rocking worldwide markets. Some investors are getting caught off guard by the volatility. The volatility could lead to meaningful declines by year-end. On Monday morning, many investors woke up to see Dow futures down 500 points and the S&P (NYSEARCA: SPY ) futures down 3%. CNBC and Bloomberg have finally gotten the memo that the drop in the Chinese equity markets is serious. Forget Greece, forget interest rates, forget oil and forget the dollar. Those issues do not matter at the moment. The Chinese markets are in free fall and it will bring the international markets to their knees for the rest of the year. Wall street needs to come back from the Hamptons and start preparing for a serious correction. Understanding why the correction in China is not just a temporary issue requires an understanding of what pushed the market up over the past year. From June 2014 to June 2015, the Shanghai increased from 2000 to nearly 5200, a 160% increase. A large part of the run-up was funded by retail traders. Source: C alculatedRisk The Chinese markets have been largely bolstered by non-professional investors. These individuals own 85% of equities in that country. China, today, is akin to the US in 2000, when retail investors were pumping up stocks, despite truly understanding those investments. Chinese equities are rife with frauds and over-hyped companies with no tangible models of growth. These are major issues in that country and a large part of the sell-off. As those firms lose the confidence of investors, their stocks will continue to drag down the indices. With the vast majority of those involved being everyday middle-class investors, the dramatic declines will hit their consumption behavior. The Chinese economy, unlike the US, is not entirely reliant on consumer spending. Consumer spending is just ⅓ of the Chinese economy. That represents about $1.8 trillion. A large percentage of that is directed towards American products available to the Chinese people. A market decline may not cause significant GDP contraction, but will cause headaches for foreign companies in China. Source: McKinsey North American consumer discretionary companies, over the past several years, have relied heavily on growth in China to offset sluggish demand for their products in Europe and the America’s. Autos, technology manufacturers, and retailers have grown the top line, in large part, by expanding in China. If middle-class families, which represent 75% of consumer spending in that country, are seeing their wealth decline as the markets wipe out gains, they will reduce buying of American discretionary products, as the wealth effect would suggest. This is what turns this correction into a full-blown downturn for the American markets. US firms can no longer rely on China to bolster the often limited growth worldwide. Yum! Brands (NYSE: YUM ) relies on China for over half of its revenues. General Motors (NYSE: GM ), Wal-Mart (NYSE: WMT ) and just about a quarter of S&P firms are deriving the majority of their expected growth from China. Once spending in that market slows, these firms will be hard pressed in reaching their respective growth targets. The impact of the market meltdown and its effect on consumption should start to materialize in Q3 earnings and become very apparent in Q4. Investors should expect significant revisions to year-end estimates. The lowering of estimates and the eventual decline in EPS should keep the US markets lower for the remainder of 2015 and into early 2016. Markets in North America have traditionally lagged during a correction. The Asian markets began collapsing in June and the US markets are just now (as of last week) starting to fall in a serious manner. The good news, well somewhat good, is that the S&P does not tend to fall as significantly as the Shenzhen or Shanghai. While the downturn here may not be as severe, it will still cause major issues for the rest of 2015. Wall Street has gotten a pass over the past three years as the markets broadly went up. Money managers did not need to do much for returns to materialize. That is not the case going forward. Investors and professional managers need to prepare for a slow growth environment in China. A decline in the indices does not mean investors cannot make money. In July, I suggested three ETFs that trade alongside Chinese volatility. (NYSEARCA: YANG ), (NYSEARCA: YXI ), and (NYSEARCA: FXP ) are all short the Asian equity markets. Each have exploded in the past three months. If the declines persist, as I suspect, these ETFs could still have room to run. Additionally, Shorting American firms which rely heavily on China could be a great move. In June, I suggested a short on NHTC (NASDAQ: NHTC ) because that company obtains 93% of their revenue from China. That has paid off with the stock dropping by 47%. Herbalife (NYSE: HLF ) is another play here. Unlike NHTC, Herbalife has not seen a material decline in its stock, yet the company relies on China as its only growth market. If Herbalife loses growth from China, the company will massively miss the already declining revenue estimates. China is entering a downturn that will continue to wipe out trillions of wealth held by their middle class. This will turn into less consumption of American products and, therefore, lower revenue figures in the coming quarters. While the ETFs that track volatility are spiking, and may seem too risky now, there are still ample ways to make money in this market by looking at firms which disproportionately rely on China for their growth projections. Keep your eyes open and this downturn can be positive for your portfolio. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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