What comes around...

The stock market semi-tanked yesterday, although it did make a late day mini-rally to close off its highs. The stock market opened strongly down this morning. Corporate earnings disappointing? Not really. Protibability is strong and exceeding expectations relatively well overall. Revenue has been a bit below expectations but nothing tragic. True, forecast for future quarters have come in dimmer than expected but still not enough to change the tone of the market overall.

So what's the story of the past two days and will it continue?

I think its China. The reality of the past months has been that China has led global growth - while i think this story is exaggerated somewhat, it has certainly helped lead in commodities growth and demand. It has experienced over 10% GDP growth this past year largely due to financial initiatives that severely eased lending standards and attempted to create/encourage a more consumer driven economy. Just as Americans need to lessen debt, China needs to save less. However, these initiatives are believed to have now created a housing bubble in China, not dissimilar (as least in theory and systemic behavior) to the one that just popped in the US. This week China instructed its banks (state-owned mind you) to restrict lending. This means that China's bubble will deflate some if not pop. This could mean that China can't lead global growth as strongly as it previously was. This means that other nations are weaker as a result. And this means that the US dollar may rise as a safety play for people's money/investments.

Couple this with Nouriel Roubini's statement (from late 2009) that the US dollar was decreasing in value as the result of carry trade actions and that it was undervalued as a result. This in turn helped raise the price of commodities as well. If the dollar starts to rise quickly, then people will see this trade as falling apart and attempt to exit it quickly. When everyone sells at once, markets fall dramatically.

Will this story play out for more than just today and tomorrow and morph into a full out problem? Unlikely considering that the Fed Reserve is keeping its rates at near 0% and the value of the dollar is likely to stay low accordingly. However, could China's actions and the realization of the problems of the US carry trade actions lead to a quick correction and bring markets back to more fair valuation levels? Personally, I hope so.

The carry trade consequences will have to be addressed but won't be until the economy recovers and the Fed decides to raise its rates. Unfortunately (as China is discovering) the longer an inflationary/bubblicious trend goes on, the more complicated (and less possible) it is to deflate it in an orderly manner.