As China Goes, So Goes The World?

Conventional wisdom is that China now calls the tune. You cannot read a commodity industry report without the assumption that China is the prime mover, and plenty of U.S. commentators have warned of the potential dire effects of a Chinese property bubble on U.S. equity markets.

But is this really true? Let's investigate.

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Calling the Tune on Commodities?
On first examination, it would seem that the commodity folks have a point. After all, China is the incremental demand variable for a huge number of commodities. If you compare the iShares China 25 Index ETF (NYSE:FXI) to the iPath Commodity Index (NYSE:DJP), you see a pretty close correlation between the performance of the Chinese stock market and the performance of a basket of commodities. (For more, see Investing In China)

Going a step further, it probably will not surprise investors to hear that the performance of the stocks of companies like iron ore giant Vale (Nasdaq:VALE) and diversified commodity producer BHP Billiton (NYSE:BHP) are significantly influenced by what investors are feeling about China. Certainly that makes sense, as both companies send significant tonnage of their products to China.

But It's Not Just Commodities
Here is the problem with the "China rules commodities" theory - it is not just commodities. If you compare the performance of Intel (Nasdaq:INTC) to the China 25 Index over the same time period, you get an even better correlation than with the Commodity Index ETF. Even Whole Foods Market (Nasdaq:WFMI) showed pretty close correlation until the last couple of months, and Pfizer (NYSE:PFE) is strongly correlated as well. As you might imagine, though Whole Foods and Pfizer have some business dealings with China, it is not a huge factor in their businesses.

In point of fact, the S&P 500 itself shows pretty close correlation to the performance of the China 25 Index and the Shanghai Exchange.

Correlation Is Not Causation, But...
You do not study science or statistics very long before you hear at least one professor say "correlation is not causation". In other words, two variables can appear to be co-travelers, but that does not mean that one has any influence on the other. I would not go so far as to say that there is no linkage between what is happening in China and what happens with commodities or American stocks, but it is a more complicated story.

As we have all heard and seen, the world is increasingly interconnected. As Greece looked ready to implode, we felt the pain in our own markets. Likewise, with China being both a major consumer of material inputs and a major export factory for the developed world, there is no way that China's market is not connected to our market, the European market and the overall world economy. Going a step further, as the world economy goes, so goes the demand for (and price of) commodities. (For more, see How Economic Reality Influences The Market)

Butterfly Effects
Consequently, I would caution investors not to buy or sell commodity stocks only because of the wiggles and waggles in the Chinese stock market. Likewise, it is possible that the Chinese property sector could be in for a rough ride, but the Chinese export sector could rebound with a wider global economic recovery - setting up the possibility that the Chinese stock market could be weak due to domestic troubles, but commodities and world stock exchanges could head higher on their own growth prospects.

The Bottom Line
At the bottom line, investors have the unenviable task of sifting through reams of conflicting data every day. What generally works out in the long run, though, is favoring solid long-term theses over correlations and presumed linkages. If you believe that economic growth will once again send energy and metal prices higher, by all means go long on the ETFs and stocks behind those commodities. But if you are waiting for the Chinese stock market to tell you what to buy, you just might find a lot of mixed signals. (For more, see Top 6 Factors That Drive Investment In China.)

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