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“The Shanghai Composite is an excellent leading indicator for the S&P 500.” –Jeff Gundlach

The Shanghai Composite is rallying nicely today for what feels like the first time in what’s been a horrific period for the index. Since its peak less than a month ago it has lost nearly a third of its value. This amounts to roughly $4 trillion in losses, greater than the value of the entire German stock market. This should be of great concern to US investors because there are many similarities and connections between our equity markets and theirs.

First, it’s plain to see that global equity markets’ long-term cycles harmonize. They don’t always move together over the short-term but the major trends are broadly correlated. Most importantly, major tops and bottoms seem occur simultaneously. If the Chinese stock market just witnessed a major market peak, it may suggest our market could also be in the process of peaking.

This close correlation is due to a multitude of factors but it’s probably fair to simplify by saying that as companies and economies have become more and more globalized they have also become more and more synchronized.

One key component of this rising globalization has been rise of the Chinese consumer. GM is a great example. In June, GM sold just about as many cars in China as they did in the US. Apple has also benefitted greatly from the success of the iPhone with the Chinese consumer which has recently become responsible for a huge portion of the company’s growth.

Considering that 80% of Chinese urban households have been affected by the crash in the stock market, it’s hard to imagine there won’t be repercussions for companies whose success is dependent upon them. In fact, recent reports show that GM’s China sales are falling for the first time in years even as they cut prices a whopping 20%.

All in all, the Chinese consumer has represented one of the greatest hopes for global growth until the stock market crash. Time will tell just how much it affects companies like GM and Apple and the broader global economy.

It’s also important to understand that the stock market bubble in China was intentionally manufactured by the People’s Bank of China in an effort to support its flagging economy which is suffering a real estate bust amid the burden of a massive private debt load. A failure to rescue the economy by inflating consumer wealth could trigger a daisy chain of economic troubles for the country. This is why the People’s bank is so obviously desperate to support the stock market right now.

In some ways, the Chinese example parallels our own. We also suffered a real estate bust which the Fed responded to by explicitly targeting the asset markets in hopes of creating a wealth effect. And it has worked beautifully.

Ultimately, the greatest consequence of a stock market crash in China could be the simple realization that even a completely autonomous, communist government is not omnipotent when it comes to the markets. It’s not capable of defying market forces and human nature. It’s simply not possible to have a boom without a bust.

The one major difference between the Federal Reserve and the People’s Bank of China is that the Fed is out of ammo. We are very near or have already reached the end of the credit super cycle. If the economy slows again, lowering interest rates to spur more private debt can’t save us this time.

The Fed’s other tools, like quantitative easing, are mainly effective at boosting the wealth effect through rising risk assets only to the degree that investors believe they are effective. And if the Chinese example begins to disabuse investors of this faith in the Fed we may soon discover that there’s not much else holding risk assets up at this point.

For more detail on the Chinese stock market bubble read this.