If you ask people what they know about the Chinese economy and stock market, many of the responses you’ll hear are either outdated or just plain wrong.
The first thing you’re likely to hear is that China makes everything we consume. That’s a lot further from the truth than it used to be and, more importantly, it’s irrelevant to investors like us.
You’ll also hear that Chinese stocks are a solid gauge for copper and, therefore, a good way to forecast building and development in general. That type of generalization may fly in an economics class, but it doesn’t do us much good in the real world.
|Some perceptions that investors have about China’s stocks and its economy are just plain wrong.|
Although what passes for accepted wisdom on China is relatively useless, I still look at a chart of the Shanghai Composite every week, and I pay particular attention to the support and resistance levels. Why? Because Chinese stocks do have an unmistakable link to the U.S. market.
One of the most enlightening metrics I look at each week is a chart I created comparing the Shanghai Composite ($SSEC) to the S&P 500 ($SPY). As you can see, this ratio has been in a falling channel since the U.S. market hit bottom in March 2009.
Even more troubling for investors betting on a Chinese recovery are the technical indicators incorporated into the chart. The thin red and blue lines represent the simple 50- and 100-day moving averages, and the top chart is the Relative Strength Index (RSI), a widely used measure of momentum. Both indicators support the view that the Shanghai Composite will continue to weaken against the S&P 500.
There are three scenarios under which the main line in the above chart will continue to decline. Chinese stocks can fall, while U.S. stocks remain steady, or drop at a slower pace. Chinese stocks can rise, while U.S. stocks rise faster. Or Chinese stocks can fall, while U.S. stocks rise.
This last scenario has been playing out over the past several years, and I believe it’s the scenario we’ll continue to see in the future. The reason is simple: the theory of Occam’s razor states that among competing hypotheses, the hypothesis with the fewest assumptions is usually the correct one. In other words, a continuation of the current paradigm is more likely than a paradigm shift.
If this turns out to be the case, it will be bad news for Chinese stocks, and good news for U.S. stocks.