Shanghai Composite - Weakness In China

Let’s get back to possibly the biggest topic of the year. That is the crash in Chinese stocks and the weakness in its economy. The table below breaks down the Chinese market’s performance in the past year using the new sectors.

As you can see, the median communication services stock is down 49% as investors are shirking growth. The median tech stock is down 44%.

The financial sector has the highest weight as it is 25%. This means the 33% decline in median financial stocks has helped the index.

Much is made about how the American stock market has outperformed because of its massive internet names. However, in the past year, American internet names have outperformed. That happened in part because the American economy has done well.

When the economy reverses, the high beta tech and communication services stocks will be the first to falter. We’ve seen that play out modestly in the recent October correction.

The chart below shows the Shanghai Composite is highly correlated with the MSCI world automobiles and component industry group index.

The Caixin manufacturing index has been falling steadily this year. It fell to a 16 month low in September.

Chinese consumer confidence index is historically elevated. However, has been weakening in the past few reports. It peaked at 124 in February.And it was at 118.6 in the most recent report which was in August.

Chinese fixed investment growth fell to 5.3% in August which is its slowest level on record. The peak this year was 7.9% in January and February. I’m interested to see the readings since then. The slowdown will be combined with the negative impacts from the trade war.

Clearly, the Chinese stock market knows more negative data is coming.

Shanghai Composite - Stocks Present Another Buying Opportunity

S&P 500 gave back most of its gains from Tuesday on Thursday as it fell 1.44%. Nasdaq was the worst hit as it fell 2.06%. Russell 2000 fell 1.82% and VIX increased 15.29%. I’m very bullish on stocks in the next month. B I’m neutral for the next 12 months because of the negative setup I see in 2019.

The CNN fear and greed index fell from 14 to 12 on Thursday which signals extreme fear.

The real capitulation is in international stocks. EEM emerging markets ETF fell 2.63%. At 39.30, it is only slight above its bear market trough of 39.14. This was hit on October 11th.

Tencent stock hit a new year low as it fell 3.98% to $35.01. The Shanghai Composite index fell 2.94% on Thursday. Meaning, it is now down 30.12% from its high on January 26th.

As you can see from the chart below, the S&P 500’s average return when Chinese stocks fall over 10% is down 4.81%.

The S&P 500 is up 27% of the time in these corrections which have occurred 52 times since August 2008.

Shanghai Composite - Sector Performance

Facebook underperformed the Nasdaq and the communication services index as it fell 2.82%. The news of Facebook falsifying video views is causing investors to second guess the name.

Even if Facebook wins the lawsuit, its reputation has still been hurt. The main question is if the media and advertisers can afford to stop partnering with Facebook. It seemingly has too much control over the time people spend on the internet.

With Snapchat losing users, there are not many alternatives.

Phillip Morris was one of the biggest gainers in the S&P 500 as it rallied 3.5%.

Extreme fear is exactly the scenario this consumer staples name thrives in. It beat EPS and revenue estimates. These came in at $1.44 per share and $7.5 billion instead of $1.28 and $7.17 billion.

Those two names I highlighted give you an idea of the action in each sector.

Every sector was down except the utilities and real estate which were up 8 basis points and 1 basis point. The worst sectors were consumer discretionary and technology which fell 2.11% and 1.84%.

As you can see from the chart below, the materials, energy, and financials are the worst performers. This happens when the Chinese stock market falls more than 10%.

The American economy outperformed in 2018. However, next year might be different with Fed rate hikes, tariffs, and the stimulus losing its effectiveness.

Shanghai Composite - Modest Rally In Treasuries

It looked like the treasury market was going to start skyrocketing early in the afternoon in a flight to safety trade. But it reversed late in the trading session ending with a modest gain.

The 10-year yield fell 5 basis points to 3.16% at 2:00 PM, but closed at 3.18%. The bond market sold off in August and September while stocks rallied.

We might be seeing a return to the normal negative correlation between stocks and the long bond. It’s too early to tell.

The 2-year yield fell 1 basis point which means the difference between the two yields fell to 31 basis points.

There are so many new factors impacting the bond market. The Treasury and Fed are increasing the supply. Inflation is decelerating. GDP growth is decelerating. And the net short position in the 10-year bond is at a record high.

Stocks still haven’t fallen enough to affect the Fed fund futures market. There is now an 82.1% chance of at least 1 more hike this year.

The chart below shows ECRI has the same thesis I do about falling inflation. As you can see from the chart below, year over year headline and core CPI have been falling.

Shanghai Composite - Conclusion

I think this correction remains a buying opportunity as stocks are oversold.

That being said, the weakness in China is starting to come overseas. It’s another negative catalyst to be mindful of next year as stocks already must deal with a hawkish Fed.

There are discussions of the Fed hiking rates above the long run rate. It’s a motto where the Fed hikes until something breaks. That’s the type of tight policy which causes recessions.