Birth of the Cool: A New Bull Market for Chinese Equities?

• Shanghai breaks bear market trendline and takes the FXI with it.
• Long-term relative action suggests the FXI is no longer a world laggard, but a leader instead.
• Shanghai correlation with commodities argues for higher commodity prices in general.
• Chinese materials, real estate and energy ETF’s break to the upside.

The global bull market in stocks began in 2009 and still continues, but in China, the Shanghai Composite bottomed in late 2008 and peaked merely a year later in July of 2009. Since then, it has slowly been eroding away in a very torturous bear move. That is, until last week, when we finally saw a tentative breakout for the Shanghai Composite above its bear market trendline (Chart 1). If that breakout holds, and there are few reasons for expecting otherwise, last week’s action probably heralds the birth of a new bull market, or at the very least, a major rally.

Down trendlines get their significance from their length, the number of times they have turned back rallies and the angle descent (the shallower the better). This line is important on all counts. You might think the two false breakouts flagged on the chart invalidate it, but in my book, one or two false breaks enhance a specific line as a resistance area. Remember, a trendline is a dynamic level of resistance (support for an up trendline). If the price breaks through but cannot hold above the line, that action reinforces its role as a resistance point on the chart, since the price was unable to maintain that breakout. By the same token, if we can observe three or more such breaks, that is really stretching the rule and strongly suggests the line should be re-drawn. The Shanghai bear market trendline in Chart 1 has been touched or approached on numerous occasions and is therefore very important, which means that its violation should be followed by a strong price move. Indeed, you could say that the Chinese stock market has just formed the second bottom in a giant double bottom formation. That is speculation at this point, and will be until the pattern is completed with a break above the dashed green trendline, just above 3,400.

Chart 1

Chart 2 shows recent years in greater detail. You can see that the Index has crossed above its 65-week EMA as well as the down trendline. If a breakout develops when a security is overbought, that breakout can be legitimately questioned. That is what happened during the April 2010 whipsaw break. However, the current break has occurred under the context of the short- intermediate and long-term momentum series (KST) being in a rising, and therefore supportive, mode. None of these indicators are overbought, either.

Chart 2

Sometimes the iShares FTSE China ETF, the FXI diverges in its price action with the Shanghai itself, but you can appreciate from Chart 3 that it has confirmed the $SSEC by breaking to the upside. In this instance, it has completed a 6-year inverse head and shoulders pattern. Note the recent low was accompanied by expanding volume as this ETF experienced a selling climax. Since then, volume has been declining, which is normal after a selling climax. However, in the last week, activity began to pick up noticeably again, thereby adding support to the view that the breakout will hold. Stockcharts.com does not give us volume for the Shanghai Composite, but other sources confirm that it has recently expanded as well.

Chart 3

The FXI versus the World

Chart 4 compares the absolute price of this ETF to its relative action to the MSCI World Stock ETF, the ACWI. The top two panels show absolute price and its long-term momentum action and the lower two, the relative performance. I call this my Global Nirvana template as it gives me a quick overview of the long-term absolute and relative technical position of the country ETF being plotted. The FXI/ACWI ratio in the third panel has very tentatively broken above its bear market down trendline. I am not prepared to call it a valid break at this point because it would have been possible to construct the line in a more conservative way, but with no breakout. However, given the other evidence and the fact that the long-term momentum (KST) for relative action in the bottom panel has started to turn up, there are pretty good odds that the RS line will experience a more decisive upside break.

Chart 4

Incidentally, you can click on this chart and save my Global Nirvana template as a chart style for the purpose of analyzing other country ETF’s and their long-term relative strength position, if you so wish!

Chart 5, for instance, shows how useful this exercise can be as it reflects a totally different position for the MSCI Netherlands ETF, the EWN, which typifies relative strength general weakness in European equities.

Chart 5

China and Commodities

One key implication of a Shanghai breakout is higher commodity prices, as John alluded to in his Market Message this weekend. Chart 6 compares the Shanghai to the CRB Composite. Both series move closely together with Chinese equities generally having a leading characteristic. This relationship did not hold prior to 2006, probably because China did not have the economic clout it now experiences.  In the current situation, the lead/lag relationship appears to have turned on its head and the CRB was the first to experience the breakout. I would certainly like to see some confirmation in the form of a joint breakout above the two dashed blue trendlines at around 310 and 2,300, respectively.

Chart 6

Chinese Sectors

Charts 7-11 feature several listed Chinese sector ETF’s. Once again, the information displayed is in my Global Nirvana template, where the relative action in the lower two panels is compared to the ACWI.  The three strongest sectors are Materials, Energy and Real Estate, shown in Charts 7, 8 and 9. All three have just broken to the upside. Note the material absolute KST in the second panel of Chart 7 looks as though it is very overextended. However, if you look at the number on the left, you can see that it is a negative one, indicating this indicator is still below zero.

Chart 7

Chart 8

We have heard a lot about the coming Chinese real estate crash but this news has clearly eluded investors in the Chinese Real estate ETF, the TAO, as both the price and relative action have broken to the upside.

Chart 9

The Global X China consumer ETF (CHIQ) has experienced a tentative upside break, but this ETF, along with the Global X China Financials (CHIX), have yet to experience positive KST action on either an absolute or relative basis.

Chart 10

Chart 11

Finally, Chart 12 features the Global X Chinese Industrial ETF (CHII). This sector is just below key resistance as is the global RS line in the third panel. Both are likely to break out  because both KSTs are bullish and re-accelerating to the upside.

Chart 12

The Bottom Line

Putting it all together, it may well be that the Chinese market is headed significantly higher as it is being supported by very positive short-, intermediate and long-term momentum. Nevertheless, markets reflect people in action and crowds can, and do, change their minds. Therefore, it makes sense to try to make an assessment of what might invalidate such a conclusion. In this case, I would be looking for a break below the red trendline in Chart 2, say below 1975, as that would not only re-confirm the bear market, but mean that last week’s upside breakout was a whipsaw. The number for a failed breakout on the FXI would be $35.50, since that would take the price below its 65-week EMA and retrace slightly more than 50% of the recent advance. I do not think that is going to happen, but it is never a bad idea to look over your shoulder and prepare for the worst.

Good luck and good charting!

Martin Pring