Beating Buy and Hold: Understanding Earnings

by Jeff Miller

Investors in stocks want to improve on the "buy and hold" approach. They want to beat the market in good times, but especially to avoid bad times. This requires active management of your portfolio, including watching some key indicators. It does not require you to become a whirling dervish, making major allocation changes with each new headline.

In this series of posts I plan to identify the major elements needed for active and sound management of your portfolio. Today's installment takes up one of the fundamental concepts, using earnings to identify a favorable market climate. Future pieces will discuss risks, market timing, and asset allocation. In each case I insist on quantification of risks and opportunities.

While no single part of this approach is the complete answer, an investor who understands and follows any one of the elements will have a significant edge. Those who embrace the entire package will be able to enjoy rising markets while monitoring and reducing risk.

Understanding Earnings

If you could have a single piece of information about the stock market -- just one -- what would it be? My choice would be corporate earnings. As you will soon learn, the market agrees with me.

A long-term investor should think in terms of buying businesses, not just stocks. The flow of earnings is the payoff for sound choices. Chuck Carnevale has written extensively and convincingly on this subject. I especially recommend his "A Primer on Valuation: 8 Examples of How Earnings Growth Drives Dividends and Returns." Taking a few minutes to study these charts and illustrations will help you understand that "cheap" is meaningful only with reference to earnings, not price alone.

As a manager dedicated to finding value stocks, I always include Chuck's FAST Graphs™ as part of my research. (See here for a good description of what he calls a "tool to think with.")

Short term, the story is a touch more complicated. Each quarterly earnings report provides a small piece of an ongoing story. The questions abound:

• Did the earnings beat expectations? The whisper number? Frequently the official earnings expectation is a "lower bar" as companies reduce expectations.
• Did revenue beat expectations? We do not like companies that continually squeeze more earnings from reduced revenue, since we know that there is an end to that story. When revenue is lacking, the earnings "quality" is lower.
• What is the outlook? Does management see things as continuing the trend? Getting better? Look out if it is getting worse!

There are other items, but outlook is the biggest.

With each earnings report we see how this plays out. There was a good recent example -- Accenture (ACN) which beat on both earnings and revenues, but still declined over 8%. The key is understanding the outlook for the next year. This is why earnings experts emphasize the need to look beyond the numbers. Stock prices often move dramatically during the earnings conference call, as management provides more color and background.

It is true for individual stocks, but it is also true for the market as a whole.

The Best Earnings Forecasts

Economic forecasts cover a wide range of outcomes, and corporate earnings follow these fluctuations – and with much greater variations. What if we had a source of information that provided a forecast of market earnings that had an average annual error of only 0.6% over more than ten years? In 8 of 11 years the accuracy was within 10% of the final result. Overall, the results were a little too pessimistic, but not by much.

This is more than just good forecasting. I would give it an "A."

Here is the actual track record of these real-time forecasts.

What is this great source? The much-maligned bottoms-up forecasts of the professional analyst community, as compiled by Thomson/Reuters.

The actual data show the inaccuracy behind one of the most deeply-held elements of Wall Street Truthiness. It is commonly believed that analysts are wildly optimistic and biased in the coverage of the firms they follow. Any time forward earnings estimates are mentioned, all of the pundits will agree that they are "much too high and must move lower." This is usually accompanied by citing numerous "headwinds," a favorite term for those using words rather than data. When this is mentioned on CNBC, the anchors will all nod wisely in their agreement.

If only someone asked the tough question about past records instead of posting something about "Street Cred" showing the success of their marketing departments! None of these pundits ever produces an earnings track record of his own.

The only big downside miss was the recession effect. An active investor needs to pay attention to recession risk.

The Squiggle Chart

The best way to understand earnings forecasts is to look at a "squiggle chart." You do this by picking a particular year. Let us try a few examples. In each case we want to go back about fifteen months from the last point on the line. We are trying to evaluate how accurate the forecast earnings were for the 12- month forward period.

• 2006. Check out that orange line and you will see that the final result was much stronger than the forecast.
• 2008. It was the start of the recession. Earnings collapsed and the one-year forecast was terrible.
• 2012. The forecast did not change much. It started a little low, moved higher, and remained in an accurate range.
• 2013. Estimates were too high in the first salvo (more than one year ahead of time) but have recently been in a narrow range. The jury is still out on the final result.

  

The one-year forward estimates have proven quite accurate in most years, as you can see from the chart.

The Market Significance

Many pundits who have been completely wrong in their forecasts attribute record stock prices to the Fed, what I call Using the Fed as a Fig Leaf. The article shows that many of the problems from a few years ago are solved or much improved. Higher stock prices are justified on that basis.

But earnings are also part of the story, if you are willing to look forward.

Many observers simultaneously make two claims:

1. Analysts are too optimistic so we should ignore future earnings estimates.
2. When the "beat rate" is 65%, they say that the estimates were a lowered bar.

Does anyone else see the problem here? As the data show, the estimates are very good on a one-year forward basis.

The relationship between S&P prices and forward earnings estimates has been pretty dramatic over the last ten years. Here is a helpful chart from FactSet.

This approach is much better than the backward-looking Shiller CAPE method for those interested in current valuation. Even Prof. Shiller endorses staying fully invested while using CAPE as a sector selection method.

Conclusion

Successfully beating a buy-and-hold approach has several components. I will treat each in turn. This article emphasized earnings outlook as a key element. I will move on to consider specific risks, including recessions, as well as finding the right sectors and stocks.

Finding attractive investments requires looking ahead. It is easy to get mired in the many stories emphasizing "headline risk." I recommend finding the best method for predicting future earnings. The bottoms-up conclusions from analysts provide an excellent approach for our general outlook. You can monitor this important data at Fundamentalis, the site of earnings expert Brian Gilmartin. Here is a recent example post with an update on forward earnings.

We must also consider what P/E ratio is attractive -- also a subject for another day.

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Earning`s Season Is Starting to Look Like a Disaster

By EconMatters

Earning`s season is starting to ramp up, and its abundantly clear that we have a problem. We had this occur last year as we were pushing all-time highs in markets, and the bulls wouldn`t let stocks drop even as a couple of misses started happening. Then on a Friday before option`s expiration, all hell broke loose because there were so many misses and stocks getting killed that the carnage was too much to fight, and the bulls capitulated. 

This earning`s season is much worse as almost every single company is missing on the revenue side, companies haven`t figured away to manipulate this portion of earnings as easily as the EPS number via stock buybacks. But things are so bad major equity bellwethers like Goggle, Microsoft, and Intel are just plain missing by any quarterly metric.

The bulls will try to counter this weakness by pushing up other stocks, but this can only last so long after about 30 misses, and the entire market just falls off a cliff because there are so many shorts attacking individual earning`s misses on stocks, that the cumulative effect overwhelms even the most optimistic of bulls.

By my count we have about 10 misses this far into earning`s season, only 20 more to go before the real selling takes over in markets! Earning`s season used to be good for stock prices, and it is because so many firms need to manipulate their EPS number, that they are all busy bees buying up shares to beat their awful EPS target number by one cent at all costs. They know where they stand after the quarter, now they start buying back shares like crazy to meet this EPS target. What a scam, and it is completely legal.

But the problem with earning`s season with stock prices at all-time highs is that anybody in one of these stocks that has an earning`s miss loses a lot of money real quick. So earning`s season now more than anything resembles a flashlight in a dark room at night, as all the bull cockroaches flee for cover. It acts as a massive dose of reality for the overzealous bulls who wrongly figured that stocks cannot fall in a QE injected market.

Well not only can they fall, the bulls may very well have bought at the top of the QE market this week as tapering starts in September. The market probably drops like a rock after an additional 20 earning`s misses in the next few weeks. And given that it often takes 13 days of aggressive selling to get out of positions by firms, do you think everybody is going to wait until September to actually start unwinding their exceptionally levered positions?

Don`t everybody run for the exits at the same time folks. Remember to walk, and not run! Just imagine the carnage on the way down as everyone starts selling their 13 days’ worth of positions at the same time. You literally can just close your eyes and hit the sell button.

Once the ETFs kick in this is going to be one of the most “unsteady” portfolio rebalancing events that we have experienced in recent time with asset prices so far ahead of ‘reasonable valuations’ things are going to get extremely ugly, real fast!

What is that old market adage, stocks take the escalator up, and the freight elevator down. Well, the problem is that not everybody wanting to sell this time will be able to fit in the elevator, so there will be crushed bulls piling on top of the elevator trying to liquidate positions, and unfortunate, slow-witted bulls hoping for more fed buying to save their ever-decreasing portfolios a la David Einhorn with his Apple stake! He rode that baby all the way down $300 a share. These bubbles always end the same way!

Thank you Ben Bernanke when all is said and done you are going to be remembered as the worst Fed President of all time! The man who created the largest asset bubble in the history of markets, and left the fallout of the flawed policy for somebody else to fix! This is no different than Angelo Mozilo of Countrywide, that`s a nice legacy Ben. I hope you are proud of yourself!

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6 Technologies To Crush Peak Oil

By Oilprice.com

Oil and gas is getting bigger, deeper, faster and more efficient, with new technology chipping away at “peak oil” concerns. While hydraulic fracturing has been the most visible revolutionary advancement, other high-tech developments are keeping the ball rolling—from the next generation of ultra-deepwater drillships, subsea oil and gas infrastructure and multi-well-pad drilling to M2M networking, floating LNG facilities, new dimensions in seismic imagery and supercomputing for analog exploration.

ADVANCED SEMI-SUBMERSIBLES & 6^TH GENERATION DRILLSHIPS

Rig advancements are coming online in tandem with the significantly increased momentum to drill in deeper waters as shallower reserves run out. For 2012, 49% of new offshore discoveries were in ultra-deepwater plays, while 28% were in deepwater plays. What we're looking at now are amazing advancements in deepwater rigs, with new semi-submersibles capable of drilling to depths of 5,000 feet or deeper. Beyond that, though, new sixth generation enterprise-class drillships can go to depths of 12,000 feet! From a global perspective, there are 120 ultra-deepwater rigs in existence—and demand is on the steep rise.

SUBSEA PROCESSING

Subsea processing can turn marginal fields into major producers.

Subsea production systems are wells located on the sea floor rather than the surface. Petroleum is extracted at the seafloor, and then 'tied-back' to an already existing production platform. The well is drilled by a moveable rig and the extracted oil and natural gas is transported by riser or undersea pipeline to a nearby production platform. Subsea systems are typically in use at depths of 7,000 feet or more. They don't drill, they just extract and transport.

The real advantage of subsea production systems is that they allow you to use one platform—strategically placed—to service many well areas. And as the cost of offshore production rises, this could represent significant savings.

Subsea production could rival traditional offshore production in less than 15-20 years, and we're looking at expected market growth for subsea facilities of around $27 billion in 2011 to an amazing $130 billion in 2020. Analysts expect E&P companies to invest more than $19 billion in subsea production equipment in 2013 alone--and up to $33 billion by 2017.

Subsea processing can handle everything from water removal and re-injection or disposal, to single-phase and multi-phase boosting of well fluids, sand and solid separation and gas/liquid separation and boosting to gas treatment and compression.

Subsea processing allows producers to separate the unwanted elements right on the seafloor, without using complicated and expensive flowlines to bring these elements up to the above-water processing facility to remove them and then send them back down to the seafloor to be re-injected. We're cutting out the middle man here. The middle man in this case is the process known as “subsea boosting”.

What we're talking about, essentially, is saving space and time (which means money) by performing processing activities on the seafloor rather than sending fluids back and forth between the seafloor and the processing facilities above water.

We are particularly interested in a new subsea rotating device that promises to enhance dual-gradient drilling (DGD). This is a system being developed by Chevron, which is hoping to deploy the system is the Gulf of Mexico later this year. What the DGD system will do is render the thousands of feet of mud that is bearing down on the wellbore … well … weightless.

And then we have subsea power grid plans, which have been making progressive leaps since 2010 towards the advancement of electric grids installed on the floor of the sea to run processing systems at the site of underwater wells. It reduces the need for so many platforms on the water surface, and makes the entire process much less complicated. The ultimate goal here is to be able to operate offshore wells remotely from land—saving countless billions.

MULTI-WELL-PAD DRILLING: OCTPUS IN THE HOUSE

One of the greatest drilling developments of the last decade is multiple well pads, which some like to refer to as “Octopus” technology.

Imagine gaining access to multiple buried wells at the same time, from a single pad site. This is what “Octopus” technology is doing, first in a canyon in northwestern Colorado in the Piceance Shale Formation and then in the Marcellus shale. It's definitely not your traditional horizontal drilling.

Traditionally, to drill a single well, a company needs a pad or land site for each well drilled. Each of these pads covers an average of 7 acres. The Octopus allows for multiple well drilling from a single pad, which can handle between 4 and 18 wells. So, a single pad on 7 acres can now be used to drill on up to 2,000 acres of reserves. More than anything, it means that drilling will be faster, faster, faster … And less expensive in the long run once it renders it unnecessary to break down rigs and put them together again at the next drilling location. It's simple math: 4 pads usually equals 4 wells; now 1 pad can equal between 4 and 18 wells.

Here's how the technology works: A well pad is set up and the first well is drilled, then the rig literally “crawls” on its hydraulic tentacles to another drill location from the same pad, repeatedly. And it's multi-directional. It takes about two hours between each well drilling. With traditional horizontal drilling methods, it takes about five days to move from pad to pad and start drilling a new well.

Last year, Devon Energy (DVN) drilled 36 wells from a single pad site using Octopus technology in the Marcellus Shale. More recently, Encana (ECA) drilled 51 wells covering 640 underground acres from a single pad site with a surface area of only 4.6 acres in Colorado. Multi-well pad drilling is also revolutionizing drilling in Bakken, and this is definitely the long-term outlook for shale. It will become the norm.

It's also good (or at least slightly better) news for the environment because it means less drilling disturbance on the surface as we render more of the process underground.

SUPERCOMPUTING & SEISMIC DIMENSIONS EINSTEIN WOULD APPRECIATE

Oil majors are second only to the US Defense Department in terms of the use of supercomputing systems. That's because supercomputing is the key to determining where to explore next—and to finding the sweet spots based on analog geology.

What these supercomputing systems do is analyze vast amounts of seismic imaging data collected by geologists using sound waves. What's changed most recently is the dimension: When the oil and gas industry first caught on to seismic data collection for exploration efforts, the capabilities were limited to 2-dimensional imaging. Now we have 3-dimensional imaging that tells a much more accurate story.

But it doesn't stop here. There is 4-dimensional imaging as well. What is the 4^th dimension, you ask: Time (and Einstein's theory of relativity). This 4^th dimension unlocks a variable that allows oil and gas companies not only to determine the geological characteristics of a potential play, but also gives us a look at the how a reservoir is changing LIVE, in real time. The sound waves rumbling through a reservoir predict how its geology is changing over time.

The pioneer of geological supercomputing was MIT, whose post-World War II Whirlwind system was tasked with seismic data processing. Since then, Big Oil has caught on to the potential here and there is no finish line to this race—it's constantly metamorphosing. What would have taken decades with supercomputing technology in the 1990s, now can be accomplished in a matter of weeks.

In this continual evolution, the important thing is how many calculations a computer can make per second and how much data it can store. The fastest computer will get a company to the next drilling hole before its competitors.

We are talking about MASSIVE amounts of data from constant signal loops from below the Earth's surface. For example, geologists generate sound waves using explosives or other methods that dig deep into the Earth's surface and then are sample 500 times per second. Only a supercomputer could possibly process all this complex data and make sense of it.

We've moved beyond geographical interpretations, such as pursuing exploration based on geological proximity, like Tullow's Ethiopia play is on trend with its massive Kenya finds. This is child's play. What we're talking about is using supercomputing to tell us that standing in prolific Brazil is pretty much the same as standing in Angola; or that Ghana is analog to French Guiana.

Supercomputing advances remove a great deal of the risk involved in undertaking expensive drilling when you're not sure what's there. Supercomputing essentially puts the idea of peak oil to bed for the foreseeable future.

LNG TECHNOLOGY: FLOATING IS NOT A FANTASY

Liquefied natural gas (LNG) technology—from LNG seaborne tankers and LNG trains to floating LNG facilities have quickly gone from concept to commercialization, opening up new possibilities in new frontiers and rendering the remote—well, much less remote.
Liquefaction of natural gas is the process of super-cooling natural gas to minus 260 degrees Fahrenheit (minus 162 degrees Celsius) at which point it becomes much safer and easier to transport. After shipped to its destination, regasification plants at importing or receiving terminals return the fuel to a gaseous state.

Floating LNG production, storage and offloading concepts are revolutionary because they have the ability to station a vessel directly over distant fields, removing the need for offshore pipelines and adding the advantage of mobility—these floating facilities can be moved to a new location once existing fields are depleted.

Floating liquefaction technology can bring additional LNG supply by accessing stranded gas reserves that were previously thought to be too remote, small or otherwise challenging for conventional land-based LNG development.

Shell's most prized LNG project is its Prelude Floating Liquefied Natural Gas (FLNG) Project in Australia, which is moored some 200 kilometers out to sea and will produce gas from offshore fields and liquefy it onboard. This vessel will be six times bigger than the biggest aircraft carrier and will cost between $10.8 and $12.6 billion to build—but it also means that Shell won't have to pay rising prices in Australia's onshore LNG plants. The facility will produce about 3.6 million metric tons of LNG and 1.3 million tons of gas condensate a year.

M2M FOR OIL & GAS: GETTING SMARTER AND MORE CONNECTED

The hottest arena in the smart grid world is machine-to-machine (M2M) technology—an industry worth $1 trillion. It's relevance to the oil and gas industry should not be underestimated. Now it's about to get even bigger because the cost of sensors used to make M2M possible has fallen so much that they are BEYOND commercially viable; and wireless networks are now cheap and everywhere. This is the next frontier in cross-sector technology.

M2M device use in the oil and gas industry is set to more than double, as these technologies (including SCADA Telemetry-- supervisory control and data acquisition) emerge as key differentiators in expediting oil and gas exploration and accelerating operational efficiencies.

Adopting M2M early on enables remote monitoring and allows for more flexible control of assets from wellhead to pipeline. It also enables fiscal metering, drilling monitoring and fleet management, as well as worker safety and accident response.

It means higher productivity and eventually, lower costs for the oil and gas industry.

This is the important part: The number of devices with cellular or satellite connectivity deployed in oil and gas applications worldwide is expected to rise more than 20% over the next several years.

The top two applications for M2M in the oil and gas sector are in-land pipeline monitoring and onshore well-field-equipment monitoring.

The drivers are new regulations, rising operating costs (think unconventional drilling) and increasing competition (a lot more players on the field, and the rising ranks of the juniors).

WHO TO WATCH (AND OWN)

In the high-tech hydrocarbons game these are our four picks: General Electric (GE) for subsea infrastructure; Transocean (RIG) for deep and ultra-deepwater rigs, Schlumberger for 3D seismic, and FMC Technologies.

As upward pressure pushes up day rates for deep-water (especially ultra-deep) rigs, it's Transocean (NYSE:RIG) all the way. This year's already been a pretty good year for Transocean, despite some rather serious legal problems, and it's got a nice backlog of contracts. But we're also looking at Ensco and SeaDrill.

But hands down, it's GE Oil & Gas, General Electric's fastest-growing segment, with annual 16% revenue growth over the last three years. GE is one of the most diverse companies out there, and it has carved itself a nice niche in the oil and gas sector. And it's impressively forward-thinking—from massive LNG projects to subsea drilling equipment. GE is positioned to experience significant growth.

This year has been an amazing year for GE Oil & Gas, with a list of contracts that would impress the biggest skeptic. Since January, GE has sealed a $620 million, 22-year contract for QGC's Queensland Curtis LNG plant offshore Australia; a $333 million 16-year contract extension for Russia's Sakhalin-2 LNG plant; a $500 million contract Petrobras for new pre-salt projects in Brazil; $600 million in multiple-customer propulsion system contracts; and most recently, a $147 million deal with Statoil for carbon dioxide injection. Adding to GE Oil & Gas' market share here is the recent acquisition of Lufkin Industries. Though it had a very rough time of things during the financial crisis, GE has turned around—and quickly. Downsizing GE's Capital Division has been fortuitous, and we see huge things ahead for this company.

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COMEX Registered Gold Falls To Another New Low Ahead of Option Expiration and August Delivery

by Jesse

Registered gold on the COMEX falls to another new low for this bull market, to below 30 tonnes.
I enjoyed the perspective Harvey Organ put on it this evening.

"Tonight, the Comex registered or dealer inventory of gold lowers again and remaining below the 1 million oz mark to 950,441.152 oz or 29.56 tonnes.
This is dangerously low especially when we are coming up to the August delivery month.  Remember in June we had almost 31 tonnes of gold stand for delivery."

You have to wonder what goes through someone's mind who is short into a market structure such as this wherein the ability to deliver appears to be increasingly impractical. Do they think that they are operating on insider information? Are they?
Or is this just another example reckless disregard, fostered by large bonuses, and other people's money? If gold starts to run, the rush to the exits could be rather impressively tight.
Nick of Sharelynx.com does a rough calculation of the open interest/registered or dealer's gold. The number of owners per ounce is up to a bull market high of 46 claims for every ounce registered as deliverable. 
Granted that this is not a realistic expectation, that everyone would stand for delivery, but it is an interesting metric that shows the relative tightness.  No wonder the Gold Forwards have been negative for the past nine days.    There's a tightness in them there vaults.
Let's see what happens. Confidence in the US commodities business has been racked by scandal after scandal, from price fixing to the theft of customer accounts. Little enough effort seems to have been made to reform it, to make it more transparent and efficient in price discovery.
I am not saying that they will not be able to finesse their way through August.  There are plenty of ways to do it, higher prices being the text book example.  But one has to wonder how long they can keep this up, especially if the storms in the currency markets start blowing come November.
Stand and deliver.

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What You Should Do While the Fed Hedges Its Bets

By George Leong

Federal Reserve Chairman Ben Bernanke testified to the House Financial Services Committee last Wednesday, and there was nothing surprising in what he said. He stated that the money printing will continue until there’s improvement in the economic recovery and the jobs market.

Bernanke again repeated that the Federal Reserve might begin to rein in the bond-buying stimulus later this year, but no concrete date was given as the move would depend on some key factors.

What this means is that the trading will continue to be driven by economic headlines. While there’s a sense among many that the economy will strengthen, there are some traders who would be fine with soft economic data—because that would delay the inevitable bond stimulus cuts.

“And if the subsequent data continued to confirm this pattern of ongoing economic improvement and normalizing inflation, we expected to continue to reduce the pace of purchases in measured steps through the first half of next year, ending them around mid-year,” said Bernanke in his testimony. (Source: “Semiannual Monetary Policy Report to the Congress: Before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C.,” Board of Governors of the Federal Reserve System web site, July 17, 2013.)

Bernanke also commented on the possibility of “unanticipated shocks,” including the stalling in the global economy and its impact on the country’s economic growth.

The Federal Reserve tried to reassure the market that the easy monetary policy will continue for the “foreseeable future” given the high unemployment rate and benign inflation.

But I doubt that jobs growth will accelerate fast enough for that to happen, since the recent first-quarter gross domestic product (GDP) grew at a muted 1.8%. So, it looks like the stock market will continue to be the area of choice for most investors.

It’s also interesting that the Federal Reserve has not set an amount that will be cut in the initial tranche of the bond cutting. But that’s not a surprise since it will depend, in large part, on the key factors set by the Federal Reserve. Of course, the reluctance to earmark a dollar figure could require the Federal Reserve to open a larger cut if the economy takes off and the jobs market expands more quickly than expected.

What the Federal Reserve has done is create an investment environment where volatile swings could be seen depending on the headlines and where the market is anxiously hanging on Bernanke’s each and every word. But at the end of the day, I still believe that stocks will continue to outperform bonds.

And because of the stock market’s performance, you should continue to ride the advance. But right now, the main focus will be on corporate earnings—and if corporate America fails to deliver, we could see the stock market hesitate.

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These U.S. Companies Will Suffer as China’s Economy Slows

By Sasha Cekerevac

Keep your eyes on China. One of the themes I keep reiterating in these pages is that our world is more interconnected than many investors think. While it is certainly important to be aware of how the American economy is performing, we cannot forget that we are part of the global economy.

While the U.S. is still a large player in the global economy, we are not alone at the top. Over the past decade, the Chinese economy has grown to rival our own in size, and its effects can be felt everywhere. The Chinese economy has been a huge driver for many parts of the global economy, including commodity prices and the materials sector.

However, recent attempts by leaders in that nation to shift the Chinese economy away from a production- and export-oriented nation into one that is driven more by domestic demand is causing significant problems.

The latest gross domestic product (GDP) data for the second quarter indicated that the Chinese economy grew at a 7.5% rate, according to the National Bureau of Statistics in Beijing. That was much lower than the forecast conducted by Bloomberg, of which the median estimate was for 7.7% growth in the Chinese economy. (Source: “China growth slows to 7.5% as 2013 target under threat,” Bloomberg, July 15, 2013, accessed July 16, 2013.)

Whether we like it or not, the global economy is heavily dependent on the Chinese economy. For much of the past decade, many companies, including U.S. firms, have deliberately focused their attention on the rapidly rising Chinese economy.

With the slowdown being worse than expected, I believe that this is only the beginning and the Chinese economy will continue slowing for a considerable period of time. Because many parts of the global economy are also slowing—including the eurozone, which is a large trade partner with the Chinese economy—China’s leaders can no longer rely on exporting their way to growth.

To be perfectly frank, I believe the headline GDP number showing the growth of the Chinese economy is manufactured, so the trend is more important than the actual data point. Whether it is 7.5% or 7.7%, the trend is clear: the Chinese economy is slowing.

And what’s more worrisome to me is that there is the possibility for serious financial and economic problems in China. If the Chinese economy falls below a certain rate, which is unclear at the moment, there will be serious ramifications for the global economy.

For example, the largest producer of steel and iron announced that income for the first half of 2013 would drop by 70%–90%. Another company in China, one of the largest shipyards, is looking to the government for financial help.

I think there are many companies within the Chinese economy that are massively over-leveraged and could be susceptible to serious financial problems—problems that could spread out to and infect the global economy.

I think we could be facing a long period of time in which the Chinese economy suffers as growth continues to slow and companies face financial pressure. That could mean bankruptcies, which means government bailouts to prevent massive layoffs. If bailouts were to occur, social unrest might grow, which is the last thing Chinese leaders want.

Because China is such a large player within the global economy, we must pay attention to that nation. Already we are seeing American firms such as Caterpillar Inc. (NYSE/CAT) report a significant drop in sales within the Chinese economy.

I think companies that focus on selling basic materials and goods used for construction could suffer over the next couple of years within the Chinese economy. If a full-blown financial crisis were to erupt in China, it would seriously impact the global economy—causing an even larger drag on growth.

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