The European Union is tilting at windmills

In Cervantes’ classic novel Don Quixote, the delusional hero tells his side-kick Sancho Panza that the windmills they see up ahead are really giants, and he is going to become rich by slaying them. Of course, Sancho sees the true value of the windmills: they turn the millstones that grind wheat into flour, and then into the staff of life.

How appropriate that metaphor is to Greece!

Let me explain. The windmills represent the outrageously high level of Greek debt/GDP ratios. The EU is playing the part of the Don, mistakenly believing that throwing more debt at the problem of too much debt will produce the riches they crave.

Poor old Sancho, with his feet on the ground is played by the real Greek economy. And his common sense views are being totally ignored as the EU this weekend grapples with how to square the circle and keep Greece inside the eurozone.

The Shanghai index is in terrible shape

Meanwhile, the Great Stock Mania, that seems to have reached its zenith in China, is losing momentum – and that is a good indicator of what to expect around the globe. Here are some interesting facts about the main Shanghai index:

• The index is off around 35% or so in less than three weeks. A dead-cat bounce appears to be in progress off the Fibonacci 50% support (see chart later).

• There are around 90 million individual accounts of retail investors/gamblers (more than the membership of the communist party) with two thirds lacking a high school diploma. This body of relatively unsophisticated investors/gamblers makes up an overwhelming 85% of all trades.

• Rural farmers have set up mini stock exchanges and some spend their days trading stocks rather than farming their land. It seems the shoe-shine boys of the 1920s USA have been reincarnated as Chinese farmers.

• The entire list of shares turns over on average once a month, making the average investment period precisely one month. Are these long-term investors or are they gamblers? We know the Chinese have a huge appetite for gambling, which the authorities have actively encouraged.

• The broad CSI Index is trading at around 50 times earnings, while the Nasdaq-style Chinext is valued at over 100 times. Is that a bubble?

• Total margin debt is reckoned to be around 22% of total stock values and is now falling fast – which is highly deflationary – as Johnny-come-latelies get frantic brokers’ margin calls and are forced to sell. Trading has been halted on 71% of listed share issues. Are the authorities panicking enough yet?

• Short selling and large stock sales by insiders have been banned. Regulators always ban short selling when in a panic. In fact, the Chinese police has vowed to arrest “malicious short sellers” and curb their “illegal activity”.  But instead of containing the selling panic, these knee-jerk bans only serve to magnify them, because in order to raise cash, even solid investments must be sold, thereby depressing their prices and putting all investors under pressure to do likewise.

No matter how you slice it, these developments are highly deflationary and is having a negative effect on prices of all manner of goods. Chinese commodity prices of all kinds have recently plunged alongside shares. Social mood has suddenly turned tail.

Cash is becoming king in China, and that attitude will spread to the West eventually.

The Chinese public has been brainwashed into believing the government will always come to their rescue and stabilise the market.

Likewise, in the West, it is the dominant financial institutions that have come to rely on the central banks to be their saviour when shares dipped.

But in a full-scale panic, which this promises to develop into, there will be no central bank on earth able to tilt at the windmills. They are totally out of ammo with interest rates at or near zero (though for how long remains to be seen).

Here is a long-term chart of the Shanghai index:

Shanghai composite index chart

(Chart courtesy of www.elliottwave.com)

How’s that for a roller-coaster ride?

Even on a chart

The chart is erratic, but the Elliott wave count is pretty clear – we are in a large scale C wave down. The rot has paused right at the Fibonacci 50% support level and at the level of the A wave high – a typical support zone.

But look at the previous market top in 2007. Volatility surged, and after the first sharp decline, the market briefly rallied in a dead-cat bounce – what a magnificent shorting opportunity that was!  The market plunged hard from the 6,000 top to the sub-2,000 low in a little over a year to match global stockmarket busts. Will we see a similar opportunity this time?

Last year, after a beautiful stair-step decline off the wave A (circle) high, the market rocketed upwards as small retail investors/gamblers joined the party in droves. That is what happens in a mania.

The classic book on manias was written by Charles Mackay: Extraordinary Popular Delusions and the Madness of Crowds. I recommend it to all serious traders. As Mackay notes, all manias end in the same way.