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The China Stock Market
The Smart Profits Report: Issue #399
Wednesday, February 28, 2007
The China Stock Market: Shanghai Selloff Triggers Global Fallout… But The Warning Signs Were Already There
By D. R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
It’s hard to ignore a once-in-a-decade event. Snow in central Florida… A change in expression on Al Gore’s face… Like these unusual events, when something happens very infrequently, it commands our attention. And an event like this happened just yesterday…
While America was sleeping, the China stock market (Shanghai Composite) was in the midst of a brutal selloff that saw it dive 268 points (8.8%) by the end of the day. It was the largest single-day drop for the index since February 1997.
China Stock Market Plunge Jolts Global Markets
Traders across Europe reacted negatively, with the German, French and Spanish markets all slumping 3% and London’s FTSE-100 index down 2.3%. The major U.S. market indexes followed suit, with the Dow Industrials, Nasdaq Composite and S&P 500 down 3.3%, 3.9% and 3.5% respectively at the close today.
But here’s the big question: Is China’s slump the proverbial straw that breaks the camel’s back and sends the market into a corrective phase, or is it just a temporary hiccup in the third-longest bull market in stock trading history? More importantly, how should you react to today’s market swoon? Let’s take a look…
Global Selloff After China’s Meltdown
While the global markets sold off following China’s meltdown today, the world hasn’t yet come to an end. Consider these facts about the Shanghai Composite Index that puts some perspective on today’s big drop:
- Even after the 8.8% spill, the Shanghai Composite is still up 3.6% in 2007.
- Including today’s fall, the index is still up an incredible 174% since its lows in the middle of 2005.
- China’s government made no announcements that triggered the fall, so there is no structural reason for a continued decline.
Most pundits have reasoned that the big fall was the result of profit-taking after the big run-ups mentioned in the points above.
But for me, the “profit-taking” argument can always be loosely translated as: “We couldn’t find any other real reasons, so this is our last resort explanation.” After all, an 8.8% single-day plunge would be some of the most rabid profit-taking in history.
Here’s the more likely scenari Today’s events illustrate panic selling more than just benign profit-taking - and the warning signs were already there…
What Goes Up Must Come Down
In my message to you here last week, I wrote about the key market factors and warning signs that signal “topping behavior.” For the U.S. markets, this includes:
- Record inflows of cash into mutual funds and exchange-traded funds.
- All-time lows in the Volatility Index (indicating a high level of complacency).
- An extremely long run in the current bull market (the third-longest in history).
The same logic applies to the China stock market. Before today, it already had several fresh warning signs in place - and is extremely overbought. Even if the markets are going to head higher in the short or intermediate-term, they need some relief from overbought conditions.
In addition, the China stock markets have a 10% limit for price drops in one day and a number of stocks hit that level yesterday. This means that there could be some residual selling pressure in those stocks that didn’t reach their market equilibrium price.
Critical Direction Determined In Next 2 Days
The next two days will be critical for determining near-term direction. Yesterday’s action means the markets traded below their monthly lows, so we’re now negative for the month of February. The key issue now is whether enough buyers come in to “save the month” and put it back in the black, or if the pullback continues in earnest.
The pullback seems to be the most probable direction.
In your own portfolio, it’s vital that you honor your stops and keep your discipline. These steps are always a winning formula for long-term success.
Great trading,
D. R. Barton, Jr.
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Today’s Smart Profits Cribsheet
- Despite the Chinese stock market’s nosedive on Tuesday, the country’s economy continues to blast forward. In 2006, GDP growth hit a blistering 10.7%, the fastest rate since 1995 according to the World Bank. This year, the Bank projects a 9.6% growth rate. And that’s not likely to stop. In fact, growth is projected at 7% to 8% every year for the next decade.
- China’s economic explosion is filtering to many of its citizens, who are getting richer by the day. Personal wealth is increasing, and the country is expected to have 520 million cellphone subscribers by the end of 2007 - 60 million more than in 2006. And one small company with “haptics” technology is going to make every phone ring in a new way. Find out more about how this technology is about to explode in China.
- Because of continued expansion in countries like China, bulls contend that the copper market is set for a rebound in 2007. China’s surging economic growth means the country will have to begin buying copper on the world market once again. For complete details, check out Smart Profits #398, Copper Prices: The Bullish And Bearish Case For Copper With A Smart Profits Approach.
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- 2006 Stock Index Comparison: Here’s How To Play Both Correction or Breakout Scenarios
The Chart Of The Week
Google (Nasdaq: GOOG) has reached a critical support area. A close below the $450-452 area would almost ensure a further drop to close the gap shown on the chart below. However, if this is only a one- or two-day market pullback, look for GOOG to react quickly and decisively to the upside after this test of support.
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