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Is China a leading indicator? Part 6

Yesterday was another bullish day in global stock markets. The DOW was up almost 200 points, the S&P 500 has finally broken above a stubborn resistance level of 1150 and it looks like the bulls are in charge for now. The Australian market followed the overnight lead from the US and the All Ords jumped up 77 points as well, and it has finally succeeded in pushing above the 61.8 per cent Fibonacci retracement level. This index has retraced 65 per cent of the 854 point fall from its peak in April 2010 as shown in the chart below. It certainly looks like we are headed back up to 5000 again.

On days like these, it is hard not to feel bullish. There seems to be mainly good news with our economy – GDP and employment growth have both exceeded expectations. The pain of the 17 per cent correction in April is almost forgotten and it is tempting to jump into the market to catch the traditional year end rally. I thought this might be a good time to take another look at the Shanghai Composite index, as China has been a good leading indicator so far. When I look at the chart of the Shanghai index, I see some disturbing similarities in the stock market action in the months following their first market correction in August 2009 as shown in the shaded area in the chart below.

After a sharp 24 per cent correction in August 2009, the market rallied hard in the following three months. By December 2009, the index had retraced 86 per cent of the 838 point fall in August 2009. I bet at the time many investors must be feeling just like we do now, i.e. confident that the worst is behind us and the market is headed for new highs. At that point in time, it must be hard to imagine that the market could fall back below 2640, which was the low of the August correction. But the rally eventually ran out of steam – the Shanghai index went sideways for a few months before another steep correction took the index down to 2320, which is another 320 points below the lowest point of the first correction.

Sharp rallies that last for a few months are common in bear markets. It is easy to get excited by these but they should not be mistaken for the start of a new bull market. With the Shanghai index, a clear down trend line can be drawn and until prices clearly break above this trend line, any rallies should be viewed as bear market rallies and traded accordingly. Good economic numbers do not guarantee good stock market performance. GDP growth in China was over 9 per cent in 2009 and 2010, yet the stock market has fallen as much as 33 per cent from the peak in August 2009. Some good news for Chinese stocks is that perhaps a bottom has been reached in Jul 2010. Although the Shanghai index has not made new recovery highs yet, the Shenzen index which comprises of smaller cap stocks has. We will watch for the break in the trend line in the coming months.

For the Australian market, the latest rally still looks like a bear market rally unless the All Ords can break above the 5048 high achieved in April 2010. There are still a few bearish technical signals as shown in the chart below:

• MACD, the momentum indicator is showing a divergence with price action, just like it did in April 2010 and we can see what happened when April rally ended
• Although prices are now above the 200 day moving average, the “death cross” is still in play until the 50 day MA crosses back above the 200 day MA.

I also feel uncomfortable about the September rally because it was not driven by improving fundamentals but rather by monetary stimulus from the world’s largest central banks. Bank of Japan has already embarked on another round of quantitative easing and has officially lowered their interest rate to zero (yep, free money for the banks) and the market is expecting the US to do the same very soon. From past experience, these types of rallies do not last very long.

There are however some good reasons to be bullish about the Australian market. Many Asian and other emerging markets have recovered well from the global financial crisis and have exceeded or are close to exceeding their levels in October 2007 when the crisis started. Below is a chart that compares the broad market indexes of Indonesia and Brazil with Australia and the US.

Geographically, Australia is located in the Asia Pacific region and should benefit from the recovery in Asia, which is the biggest market for our exports. Economically, we are more like commodity driven countries like Brazil which are benefiting from the commodities boom. However, Australia does not see itself as an emerging market and prefers to compare itself with the developed world, so our stock market seems track the US S&P 500 more than the Asian indexes. So far the Australian stock market has under performed most of its Asian neighbours – perhaps its time it catches up with them.

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