Why China's stimulus failed to stanch the bleeding on Wall Street

U.S. equities again succumbed to selling pressure on Tuesday, erasing one of the strongest single-day gains of the year. Initial gains were spurred by the deliverance of what the bulls had been clamoring for on Monday -- stimulus by the People's Bank of China in the form of lower interest rates.

Despite getting what they wanted, investors still turned tail. As a result, Dow Jones industrial average lost 1.3 percent to fall further below the 16,000 level. It is the first six-day losing streak for the blue-chip index since 2012. The decline was also the worst intra-day reversal since the fallout from the collapse of Lehman Brothers in October of 2008.

What happened? In some ways, the fade shouldn't have been surprise given the response from Chinese equities to the stimulus move: The Shanghai Composite lost another 7.6 percent -- pushing the index down 43 percent from its June high below the 3,000 level for the first time since December.

Moreover, according to Societe Generale analyst Wei Yao, the move by China's central bank was meant less to ease monetary policy than to offset domestic liquidity tightening that's happening in response to the recent devaluation of the country's currency.

In short, China's rate cut may not deliver the stimulus boost that many investors are hoping for in assessing the country's dwindling growth. Not surprising, then, that what should've been a positive development actually weakened confidence further.

For investors, the fear is palpable. That has pushed the CBOE Volatility Index (VIX), known as Wall Street's "fear gauge," to levels not seen since the 2011 market scare surrounding the credit downgrade of the U.S. Treasury by Standard & Poor's. According to Nanex data, daily trading in the VIX has soared to fresh records. And in the two-days through Monday's close, the VIX posted its largest two-day gain ever.

According to Bank of America Merrill Lynch analysts, this stress should ease unless market contagion widens. In other words, the panic hitting stocks hasn't yet spread to other areas of the financial system.

The risk is that stocks could slump even more should investors and traders react poorly to a possible interest rate hike from the Federal Reserve in September.

Scotiabank's Guy Haselmann said in a note to clients that with equity prices remaining at historically high levels, buyers must believe that the Fed will not hike in 2015 or that the central bank will continue its cheap money policy with another round of quantitative easing.

JPMorgan's Michael Feroli told clients today that while the odds of a rate hike next month have declined, "We still think the odds of liftoff are greater for September than for any other single meeting."

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.