Trader’s Narrative

Peering through the fog of daily distractions, there is only really one thing that concerns me: China. It has been 5 days since the Chinese equity market (as measured by the Shanghai Composite) officially entered bear market territory. But there is much more ominous portents than trading 20% from its top in August 2009 (at 3478 points).

As China’s economy has grown in size, it has come to take a pivotal role in global economic fundamentals. Where their economy is headed not only has implications for them but for everyone else as well. If we assume that the stock market is an imperfect forward discounting mechanism for economic realities then the current weakness should give any bull some pause.

Yet, the weakness in the Shanghai Composite is nothing new really. Since its peak in August 2009 it has trailed other major indexes like the S&P 500. In late January it succumbed to the consistent relative weak performance as Shanghai fell below its long term trend line. It spent a few months playing hopscotch with the 200 day moving average until it fell firmly below it and entered a new bear market:

In general, when prices are below the 200 day moving average, they tend to perform weaker. As well, I haven’t included the 50 day moving average in the above chart but there was a “Death Cross” event in March 2010. This is where the 50 day moving average crosses from above to below the 200 day moving average. It is the opposite of the “Golden Cross” and has the expected negative consequences for future prices.

Up until now there has been a surreal disconnect between China’s economy and the Chinese real estate market with the rest of the world. Whereas most monetary conditions around the globe are either extremely loose or somewhat loose, China on the other hand has reluctantly embarked on a much needed round of tightening.

Monetary policy has already been firmed up three times this year with the central bank requiring higher reserve ratios from banks. As well, they’ve targeted the Chinese real estate bubble with tighter lending requirements and a complete ban on third-home purchases.

We’re beginning now to see prices coming down with a recent report from the Beijing Real Estate Information Network suggesting that commercial residential prices down 30% with a similar drop in transaction volumes. The problem with China’s market and why I’m so nervous about them is that the margin of error for policy makers is a razor’s edge.

If they tighten too much, too fast they will strangulate the construction industry which is the primary engine of their economy. As well, real estate development is a lucrative source of revenue for municipalities. But if on the other hand they allow the real estate bubble to get really out of hand, then when it does eventually burst from its own weight, it will wreak devastating damage on the Chinese economy. And the shock wave will reverberate through to all major economies around the world.

In other words, we will see what happened in the US, where the wealth effect went into a sharp reverse, happen in one of the largest and fastest growing economies in the world. While the US has been in a deep funk for the past few years, China’s white hot markets have taken up the slack. With the US still mired in a very tenuous recovery, I can’t help but think of the worst if a similar fate befalls China. Who is left to pick up the slack?

Based on the various technical indicators that we’ve discussed at length, I continue to be optimistic for US equities in the intermediate time frame. But if there were one issue to keep me up at night, it would be the systematic risk that the Chinese bubble presents to this thesis.