From Dan Denning in St. Kilda:

--Psychologists have an explanation for why crowds are prone to do stupid things at crucial moments. It can be action or inaction. But studies show people look to the actions of others to determine what the correct course of action is in an uncertain situation. It's called social proof. You don't want to look like an idiot, so you wait to see what everyone else is doing and go along.

--If everyone's running up the street bashing windows, you'll experience pressure to join in. On the other hand, if, say, everyone is buying stocks because no one appears to be concerned that they are expensive, you'll experience subtle pressure to do the same.

--In evolutionary terms, doing what other people are doing is generally a good strategy. It saves you the time and energy of thinking about the decision yourself. And you have to assume that they probably wouldn't be doing it if it didn't promote their survival in some way.

--The shrinks call this phenomenon "pluralistic ignorance." We were reading about it last night over cocktails at Barney Allen's, right next door to our new head quarters in the heart of St. Kilda. It made a lot of sense, at least if you're trying to explain why so many people do so little when they have so much to lose.

--Speaking of losing and just what's at stake as September begins, why don't we start with where the entire global recovery - and Australia's resilience - are supposed to reside: Chinese strength. The Shanghai Composite fells 6.7% overnight and is now down over 25% from its highs. Uh oh.

--But it's not Chinese stocks that worry us. It's true there is probably a huge bubble slowly deflating in Chinese shares. Chinese banks lent nearly $1.1 trillion in the first half of this year and a lot of that found its way into the stock and real estate markets. But the bigger issue for Aussie investors is whether Chinese industrial stockpiling of raw materials is over.

--If it is, then one of the big drivers of the resource rebound is in real trouble. You got a whiff of that overnight when October crude oil prices fell $2.78 per barrel back under $70. Investors are reconsidering the idea that China can lead a global demand recovery and justify the high p/e ratios reflected on major indexes.

--For example, yesterday's Age reports that the Morgan Stanley Capital Insights (MSCI) index of Asia Pacific stocks, "are trading at a price-to-book valuation of 1.1 times, above the 30-year average of 0.7 times and around the same level at the peak of the last bull market." These stocks are priced for an export-boom to America.

--But what if that doesn't happen? It's almost certain that it can't, given the retreating balance sheets of U.S. consumers. That leaves a Chinese growth model that's not focused on exports. That leaves China buying its own toasters, cars, ovens, toaster-ovens, clothes, capital goods, and textiles.

--Does China have the capacity, along with India, to consume the world out of deflation? Hmm. What do you reckon? We reckon all this is setting up for a traditional September/October correction. And yesterday, there was more evidence to show why that might be.

--The first and second quarters looked good for corporations because of massive cost cutting. This cost-cutting helped stocks beat "analyst's expectations." That created a bunch of manufactured enthusiasm about "green shoots." But you have to ask if the earnings outlook for firms really improved the first half? We'd argue that it didn't.

--For example, according to Goldman Sachs, 46% of Wall Street firms beat expectations by "a wide margin." But only 23% of firms actually reported better revenues than initially forecast. And for companies in the S&P 500, sales actually fell by 16% in the second quarter compared to the year before. And that was after a 14% year-over-year sales decline in the first quarter.

--Now you can make more in earnings off declining sales. But we'd suggest that is not a very good sign of health. Companies achieved the higher earnings numbers through cost cutting and tentative restocking of inventories. You reduce your overheads and your cost of goods sold and fire people. That helps you beat "analyst's expectations." But it doesn't really mean your business is primed to throw off higher earnings and cash flows next year.

--This may be why September sucks. As long as analysts are in collusion with reporting firms, you can fool investors for a quarter or two with cost cutting and some earnings engineering. But by the third quarter, the real state of the company is clear for anyone to see. All you have to do is look.

--Amy Lubas from Ned Davis Research tells the Wall Street Journal that sorting through the market now is all about "differentiation." She says that, "In the initial stage of a recovery from a bear market, the stocks that have fallen the most tend to be the ones that rebound the strongest. After a bottom, the market shifts to more industry-specific and company-specific factors."

--So if you're differentiating, what are you looking for? You're looking for the companies that have trimmed their operating overheads to become more efficient, that's for sure. But what you really want is a firm that increases its revenue growth without greatly increasing its capital spending (the secret of capital efficiency, as we have written about before).

--There is good news and bad news for commodities here. The good news is that you can always find companies with ore bodies and assets that are exposed the higher prices that come with higher demand. The bad news is that you cannot generally assume demand for all commodities will rise, or that supply will stay constrained. You have to find out which commodities are correlated to the new kind of domestic-driven growth from the Chinese economy and which are not.

And for now, the short answer is that we like LNG, lithium, rare earths, hot rocks, and precious metals. We do not, however, like commercial real estate one bit.

-- "Australian REITS Retreat Home After A$19.5 Billion in Losses," reports Sarah McDonald from Bloomberg. "Australian property trusts are unloading failed overseas investments from Munich to Michigan after piling up losses equal to almost a third of their market value in the last 12 months." She identifies the usual suspects: Westfield Group, GPT Group, Centro etc.

--How did Australia get caught up losing money in commercial U.S. real estate? In yesterday's Age, Bwembya Chikolwa, a lecturer in the School of Urban Development at Queensland University of Technology, says Aussie super funds had money to burn and listed property trusts, with their large portfolios of U.S. assets, were liquid enough to do the trick.

--"Unfortunately they were caught up in circumstances to do with the financial crisis," she says. "Moving into the US wasn't a problem because it had more or less the same settings...It was driven by large investment inflows into the super funds...The super funds needed new investment avenues and the trusts were a good avenue. So they invested through the listed property trusts. They had the funds and had no choice but to move offshore and the US market because of its size."

--No choice? A portfolio manager always has a choice. It's the retail investor who is forced into compulsory super that has less choice. But this does highlight the obvious fact that fund managers are not paid to put clients into cash. Self managed super investors can do this easily enough, and many did (whether by design or indifference), thus avoiding the share market wipeout. But big fund managers have to buy big stocks. They are too big to buy small stocks, by the way, which creates a niche for Kris Sayce at the >Australian Small Cap Investigator.

--But now we have yet another seemingly external threat to your cozy domestic retirement: U.S. commercial real estate. Yesterday's Wall Street Journal reports that the $700 billion U.S. commercial mortgage backed securities market saw a delinquency rate of 3.14% in July. That was up six times from the year before.

--The Journal reckons that over $153 billion in loans need to be refinanced by 2012. Of that amount, at least $100 billion could be in trouble. Why? The underwriting on the original commercial real estate loans was dodgy (as it always is in a credit bubble). But more importantly, with property values on commercial real estate down by 50% in some areas, refinancing at the same loan to value ratio as before just isn't going to happen.

--Cash flows are fine for debt service and principal repayment now, according to the Journal story. It's the write down in property values that will scupper the refinancing. What's more, because the loans were securitised, it's often hard to figure out who you should be renegotiating with. This is reminiscent of the residential mortgage backed securities market where Deutsche Bank couldn't proved it owned the properties it wanted to foreclose on.

--Mortgage servicers, banks, and investors would all prefer the problem to go away so no one has to take a write down on their asset values or a loss on their securities. But Aussie firms already know better. The only question now is if a pear-shaped U.S. commercial real estate market will do as much (or more) damage to the global financial system as the residential housing market. Stay tuned....