To be clear, I’m not an expert on mainland Chinese real estate companies, nor am I 100% certain (in the way I am about Jack Ma) that I know why Hui Ka-yan is on Xi’s bad list, but here’s what I think is going on:

The mayor of every Chinese city/town is a high-ranking member of the Communist Party. He/she has economic growth targets to meet in order to remain the mayor and to become a higher-ranking official. The easiest way to get economic growth is to build something. So the mayor, with a developer in hand, goes to visit the head of the local bank. The bank president is also an important member of the Party, but lower in status than the mayor, who may be key to getting the bank president promoted. So a loan gets arranged, a big project gets built, no one looks too closely at the financial underpinnings and everybody wins.

My take on Hui is that he continuously gamed the system by being very aggressive with the amount of financial leverage he was using, to the point that he was always flirting with bankruptcy. His idea was likely that this gave him the greatest profit potential and that the mayor and the bank would always prefer to bail him out than to have an important project blow up.

Last August Beijing introduced the “three red lines,” a set of rules for maximum allowable financial leverage for property developers. Hui has been either defiant or unable/unwilling to make a satisfactory effort to comply.

This is by no means a new story for anyone interested in China or Chinese stocks. The two open issues are:

–how much exposure to a potential Evergrande default non-China financial institutions have, and

–what efforts (probably none, in my view) China will take to continue to prop up Evergrande.

Given that the story is so well-known, except to western financial TV, and that Evergrande represents less than 5% of the local property development market, the current talk of Lehman-like or Long Term Capital Management(LTCM)-like damage to financial markets seems wildly over the top.

I think there is an issue for us as investors with the debt ceiling. But this may be less a fiscal issue and more a manifestation of the fracturing of Washington since Trump’s revelatory performance demonstrating the shockingly large amount of money that can be raised by politicians advocating white racism and political dysfunction. More about the fiscal side tomorrow.

Evergrande’s gigantic borrowing will doubtless be found to have reached far more deeply into bank loan portfolios outside China than markets are now aware. But this the case with any major potential bankruptcy. For the US, this is certainly nothing of the magnitude of the 2008-09 financial crisis, nor even of the savings and loan crisis, where the “Keating five” senators actively worked to stop the government investigation of crooked S&Ls. For China, though, the problem is potentially more serious.

What to do?

Day traders have a field day during a time like this. Most of us, however, have a much longer time horizon. So high on my list is avoiding doing something dumb that will mess up my long-term strategy. This implies that in most cases the best thing to do is nothing.

For me, though, a selloff is a chance to upgrade my portfolio. Typically, the clunkers I have among my holdings (everyone has them, it’s a fact of life), start to outperform–if they never went up, it’s hard for them to go down a lot. They also become more visible psychologically. So I’m on the lookout for stocks I’ve wanted to own but thought too expensive, which are typically sold off the hardest in a downturn, and trade out of clunkers.

I realized long ago that I have no ability to time the market’s ups and downs. So I’m looking for a stock that I already own that’s, say, 5% cheaper than it was a couple of weeks ago and a clunker that I’ve suppressed memory of–and which I should have sold long ago (or never bought) that’s suddenly up by 5%. If I see this situation, no matter where the market is (put another way, I’m ignoring the possibility that the spread between the two might widen), I’ll sell the latter to buy the former.

I’ve been staring out my window for the last 15 minutes or so, trying to think of a pithy way to put this. No success, so I’m writing this instead:

In the first half of the last century, Saudi Arabia’s economy was supported by taxes on Muslims making the pilgrimage to Mecca. That source of income dried up during the Depression and WWII. So Riyadh opened itself to development of what turned out to be gigantic oil reserves by the major Western petroleum companies in return for a (very small) cut of the resulting revenue.

So, a temporary dearth of worshippers triggered a mammoth, decades-long, worldwide change in the way energy is used in transport and heating, and in the materials out of which everyday objects are fashioned.

I think the pandemic has the potential to be the same kind of transformative event, implying the potential for very high rewards for investors who figure out the twists and turns this story may take as it continues to develop. I don’t think this is a “today” story for the stock market, because the exit from global crisis mode will certainly entail a rise in interest rates. This means equities will no longer be the only game in town, in the way they have been over the past 18 months or so. Another way of putting this is that concept will only get you so far.

…which brings me to what I started out to write about.

My favorite description of the stock market is that it is the arena in which the hopes and fears of investors meet the objective characteristics of publicly-traded companies and express themselves through stock prices. Two criteria: concept (sort of an elevator speech about where a company is going), and valuation (the price of the stock, relative to its expected future).

During the pandemic, my perception is that almost no one has cared about valuation. Everything has been concept. Over the past few weeks, however, I think this has begun to change. Former high-flying stocks of companies that have reported below-consensus earnings–or provided below-consensus guidance for future earnings–are starting to decline on the news. I think this is an important change of tone, away from the all-offense, no-defense mentality that had dominated 2020-21 trading until now.

I think this is a positive sign, since I interpret it as part of a more general return of the world economies to normal operation. At the same time, the price of making a mistake will be much higher than it has been to date.

I got an email last week from my brother-in-law, an experienced stock market investor, asking whether I thought we’d have the typical equity mutual fund/ETF September-October selloff in 2021.

I didn’t have a good answer then, and I don’t have a good one now.

On the “selloff” part, one could easily interpret the current market weakness as the start of the annual seasonal decline. Even if that’s not right, I don’t see any reason to doubt that the tax and dividend planning that typically produce weakness during September-October will occur.

On the other hand, I hadn’t realized until I consulted Investment Company Institute data the staggering level of net equity mutual fund redemptions that occurred during the Trump administration. They total $1.4 trillion+, or 7x the withdrawals during the financial crisis of 2008-09. They’re 3.5x the cumulative outflows during the eight Obama years, which seem to me to be mostly financial crisis-related. This suggests to me there’s still a lot of money on the sidelines. (Yes, some Trump-era withdrawals may have gone into ETFs, but total stock ETF issuance is only running at about $150 billion/year.)

So selling, yes. But will sideline money come in to absorb at least part of this? No clue.

Another point: during the latter half of Trump’s term, as the magnitude of his economic incompetence became more evident, the equity market rotated strongly away from companies whose earnings derive from the domestic economy to those with substantial operations outside the US. As the administration wilted in the face of the pandemic, rotation extended to stay-at-home beneficiaries.

Early this year, my sense is that the market began to rotate again, away from stay-at-home and international names toward domestic economically sensitives. This was primarily a valuation judgment, I think, meaning that the motivation came (as it usually does) ahead of a turn in the economic fundamentals and was based on the perception that every good thing that could possibly happen was already priced into the 2020 winners and every plausible bad thing into domestic cyclicals.

Then the delta variant emerged, adding three-plus World Trade Centers-worth of Americans to the dead each week to a total now approaching 700,000 fatalities. Oddly enough, the oath-brothers to the fallen heroes honored at the WTC, first responders who gave their lives so others could live, appear to be major opponents of life-saving vaccinations–choosing to avoid the “risk” of vaccination, but thereby causing others to die. Nevertheless, at some point the market will begin to argue that the worst is already in prices and will restart the rotation toward cyclicals.

Why go on about this? I think it’s curious. More important, after a sharp decline new leadership typically emerges. Because of this, if there is a September-October downward move for stocks, it may well mark the finale for stay-at-home and a resurgence for domestic cyclicals. In any event, it will likely be important to identify both leading and lagging groups–on the way down and on the way up.

So this may be an unusually information-rich selloff, if it happens.

I’ve just updated my Keeping Score page for August. Secular growth/globally-oriented stocks outperformed domestic cyclicals, although the delta variant may have made the story a little more complicated than that.