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Summer's hot economic lessons for investors

U.S. stock markets plunged in early trading Monday,

U.S. stock markets plunged in early trading Monday, Aug. 24, 2015, after a big drop in Chinese stocks. Trader Mario Innella works Monday on the floor of the New York Stock Exchange. Credit: AP / Richard Drew

A number of unrelated events in different parts of the investment world have provided an excellent summer school for investors. Let's start with China, where the concept of risk and reward was on display as its medley of problems rattled world markets and led to a global sell-off of shares.

Chinese stocks started a steep ascent in mid-2014 after local officials urged small investors to enter the market. The government did such a good job that it helped create a full-blown bubble. At its height June 12, the Shanghai Composite was up over 150 percent from 2014 lows. Of course, investors rarely have the wisdom to take money off the table, even when prices become completely disconnected from fundamentals and the use of borrowed money to buy stocks (margin debt) triples in a year.

Because investors couldn't bear the thought of parting with their buoyant stocks, Chinese officials stepped in to try to prick the bubble they had fostered. Unfortunately, as is the case with most bubbles, pricks often lead to pops. At its July low, the index had tumbled by more than 32 percent. For U.S. investors holding Chinese stock mutual or exchange-traded funds, the damage was not likely quite so awful, since most of our funds don't own the volatile mainland based A-shares but rather their gentler Hong Kong-listed cousins.

Consider this summertime lesson No. 1: Investors must weigh risk and reward. If you're a long-term investor in Chinese stocks, you've been rewarded amply for assuming the great risks inherent in that nation's market, so don't cry about the drop no matter how ugly your statement looked.

If you like the ride of Chinese stocks, you may be the type of investor who enjoys the wild swings of commodities markets. In the case of crude oil, the markets happen to be intimately connected to the Chinese economy. Roughly a third of global growth comes from China, and oil was one of the necessary ingredients to stoke that engine. As the Chinese market started to plunge, slowing growth has reduced that country's demand for oil.

Additionally, Iran, which has the fourth-largest proven crude oil reserves in the world, is expected to ramp up production and bring new supply to the market if economic sanctions are lifted as part of its nuclear accord with China, France, Germany, Russia, the United Kingdom and the United States.

That's summertime lesson No. 2: Reduced demand plus increased supply equals lower prices. Crude oil dropped by more than 20 percent from the end of June through the beginning of August.

Our final lesson of the summer comes from Puerto Rico, which may become more famous for the biggest municipal bond default in U.S. history than for beautiful beaches. The commonwealth has an outstanding debt of $72 billion -- bigger than Detroit's $20 billion but much smaller than Greece's $350 billion. Why would investors lend money to a tiny island whose economy has been contracting almost continually for almost a decade? Because the interest on Puerto Rican bonds is triple tax exempt, meaning that investors do not have to pay federal, state or local taxes on their interest income. That tax exclusion lured many high-tax-bracket investors into making bad loans despite fundamentals that could not possibly allow repayment. Perhaps these people thought the U.S. government would not allow a default to occur, but there seems to be little appetite in Washington for any sort of bailout.

To make matters worse, as a commonwealth, Puerto Rico cannot seek Chapter 9 bankruptcy protection in the courts, which would allow for an orderly debt restructuring like the one in Detroit. And, unlike Greece, it is unable to appeal to the International Monetary Fund, since it is not a sovereign nation. That leaves investors with a bitter fight ahead and a third lesson of the summer: Don't let the tax tail wag the investment dog. Just because you can earn tax-free interest does not mean that you can throw away all common sense.

Jill Schlesinger is editor-at-large for She welcomes emailed comments and questions.


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