Don't Blame Shanghai

It doesn't matter if you're from Tel Aviv, New York or Shanghai. You're asking the same question this morning.

Are we at the start of a major retreat? Or is this a great opportunity to get into shares and other assets?

Naturally, nobody can tell you for sure. But to reach a sensible decision, you have to understand what's happened so far, and mainly, why it happened.

 1. China did not cause the freefall in world markets. Granted, it was the first to suddenly reverse, but the drops were in A-class shares, which are available only to Chinese investors. The A-class stock market in China is considered to be secondary, with the dependability and constancy of an especially nervous poker player, because the locals in China have a very limited array of alternative investments. In short, this stock market says pretty much nothing about anything, not China's economy and certainly not the global one.

In normal times, even a 9% fluctuation on this particular market wouldn't ruffle anyone's feathers, mainly given that share prices there rose 200% in the last 12 months. Moreover, on that black Tuesday a week ago, to be precise, it is not that the retreat in China triggered a pullback in Europe. The stock exchanges in Europe only began to sink when it turned out that Wall Street was opening with steep drops.

2. The true insecurity is in America. The U.S. markets are still the ones that shape world trends. And the reason U.S. asset prices have been retreating is because of fears that American economic growth is slowing down. Several indicators show so, such as the 8% slide in January sales of durable products.

 Nobody, including former Fed chairman Alan Greenspan, is talking about recession, or a drop in GDP. What they are saying, is that growth may decelerate from its dizzying pace in the last five years.

Slower economic growth would diminish profitability at companies, therefore, there is a clear reason for share prices to drop.

How long is all this expected to take? Well, the slowdown is expected to last two or three quarters, say most experts.

3. Asset prices had risen too far. One leading pundit called the markets a "loaded gun": they rose so fast for so long that all it took was a virtual nonevent to get the gun firing. When Wall Street, and markets in Europe, Asia and even Tel Aviv are breaking one record after another without stopping, a steep retreat becomes inevitable.

It was not China. It was no specific event. Investors the world wide were so hungry for more gain and profits, that they neglected the risks. They brought stock markets to levels from which they could do nothing but drop.

4. U.S. interest rates are now the No. 1 variable. Interest rates are low just about everywhere: even here the rate has receded to just 4%. In the U.S., interest is 5.25%, and that is not low.

That is a level of interest rates that sends judders throughout the real estate market and mortgage banks, which are in turn slowing down U.S. growth. It's no coincidence, it's deliberate: the Fed sees asset prices, mainly of housing, losing all reason, and wants to nip the madness in the bud.

After housing, it's the turn of other assets too, which all have to compete with interest rates of 5.25% a year: commodities, high-risk bonds, share prices, emerging market currencies and, ultimately, the price of companies in the real market. As long as all were rising rapidly, without much fluctuation and therefore without giving investors cause to quail, interest of 5.25% didn't seem that attractive. But when prices are high and stop rising, that's another story altogether.

5. The main question is when American interest rates will reverse and start to drop. If interest on the dollar is high and so are real estate prices, and both consist of the main barrier to gains on stock markets, then the Fed could easily trigger more gains by slicing interest rates. But Ben Bernanke and other central bankers are probably quite pleased about the latest developments, and are signaling that they have no intention of lowering interest rates. Despite the recent retreat on the markets, they say, what has them worried is inflation.

Not everybody buys that. Some believe that as U.S. slows, Bernanke will have no choice but to lower interest on the dollar, and by a lot, during the coming 12 months.

That is what the markets think, anyway. The price of futures in the money market reflect a probability of 70% that interest on the dollar will drop before year-end.

It is a delicate game. The policy-makers want to stop the madness, but not to suffocate the economy and slam the brakes on the whole world.

In conclusion, to predict the direction of world markets, first you have to guess what the Fed will do about American interest rates.