What's to expect after the sharemarket's poor start to the new year

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The new year began very poorly for sharemarkets.

In the first week, the US market had its worst week since September 2011, with the S&P500 Index tumbling by 6%. One probably has to go back to the postwar period to find a worse start to the calendar year.

The Australian sharemarket fell by 5.8%. At the time of writing the market had gone through the lows of late September and mid-December 2015 and was at its lowest level since mid-2013.

2016 outlook sharemarket

As is so often the case these days, the most obvious culprit was China, although there were a few other factors involved in the selloff, including Middle East tensions and a North Korean bomb test.

The Chinese sharemarket was all over the place, and it wasn't helped by the operation of automatic "circuit breakers", which kick in when the market falls sharply. On January 7 the market was open for less than half an hour!

Not only do such mechanisms interfere with the market but they can also precipitate panic selling, exactly what they are designed to offset.

Indeed, the Chinese seem to have come to this conclusion, given that use of the circuit breakers has been suspended. For the week, the Shanghai Composite index fell by 10%.

I have said this before: the Chinese sharemarket is a casino. It tells us nothing about anything. But, of course, it's not the only Chinese factor. There is also cause for concern about the economy and currency.

At the moment, the currency may be more important than the economy.

The yuan has fallen by about 7% against the US dollar since early August 2015, from 6.11 to 6.55. This has sparked fears of a trade war, and it also affects commodity prices, since Chinese demand (eg, for oil) is likely to lessen when the yuan strengthens.

Since oil and equity markets tend to be positively correlated these days, the argument goes that the weaker yuan depresses oil prices (currently at their lowest in more than 11 years) and hence sharemarkets.

There may be something to this directionally, but it stretches credulity to think that a 7% decline in the yuan (since early August) can be fundamentally responsible for the recent sharemarket falls.

A 7% currency move is no big deal in the scheme of things (the $A has fallen by twice as much since mid May 2015), and much of the decline in recent weeks has been a direct result of the $US strengthening - hence the shift in mid December to managing the yuan against a basket rather than against the US dollar alone.

Nor does the weaker yuan reflect some sinister purpose on behalf of the Chinese authorities. China has been decreasing its stock of foreign reserves and buying its own currency, suggesting that the authorities are acting to limit the decline in the yuan.

Which brings us to the Chinese economy. First, the sharemarket movement is very unlikely to cause any economic weakness; the linkages are very small. Second, a lot of policy stimulus has been thrown at the economy. It's true that it has slowed, and probably by more than the official figures suggest, but there is little evidence that it is on the way to a hard landing.

Market declines similar to those last at the start of January always spark concerns that something worse is about to happen. One can never rule out such a possibility but on this occasion what has already happened seems to me a significant overreaction to any changes in the fundamental factors that drive markets.

On such occasions, many will repeat the mantra that "you haven't lost anything if you don't sell". I disagree strongly with this. But the fact that losses have already been made is the worst possible reason to sell.

Selling makes sense if one has reason to believe that the future market's trend is downwards. My view of the fundamentals is that this is simply not the case.

Accordingly, I continue to expect 2016 to be a positive year for the Australian sharemarket, with the ASX200 (4890 at the time of writing) likely to end the year around 5500.

What has already happened seems to be a significant overreaction to any changes in the market fundamentals

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