Does a Subtle Lack of Bullishness in a Leading Chinese Stock Auger Poorly for the Market?

Friday we came to market quite upbeat. The stock market was consolidating in a tight range, through time as traders say, rather than through price. We were anticipating adding to our position in BIDU, which has been one of the market’s leading stocks, at the end of the day.

Like the market BIDU had made strong gains during the late July rally and had consolidated in tight fashion since. At the close Thursday BIDU’s weekly chart showed three consecutive tight weekly closes. O’Neil says that sort of action can be a reason to add to a winning position. Of course a Thursday close on a weekly doesn’t count. We needed to see continued steadiness Friday before the pattern was confirmed and we could add. We were ready.

But an ugly thing happened to BIDU on Friday. It took out the bottom of its pattern. Not to worry, we thought. Trading was on light volume and it could always rally back into the close making the setup all the more bullish for having tested the downside. And indeed the market showed some of the resilience we’ve come to expect of it the past month and rallied into the close. We expected that BIDU, one of the strongest stocks in the market, would be leading that charge. Instead it was financials that recovered a bit. BIDU was mostly left behind closing at the low end of its range. Not the kind of action you’d expect from a leading stock.

Should we be that concerned? We think you need to be on guard and here’s why.

BIDU isn’t the only leading stock to show disappointing action of late. Last week saw NTES completely break down. And GMCR has pulled back to its 50 MA. The pullback was in light volume and looks constructive, just what you’d want of a leading stock when it corrects. But it’s correcting to a far greater degree than the market. If GMCR is a true leadership stock it should be correcting sideways, if at all. Such underperformance by leading stocks in a market uptrend is a cautionary sign for the health of a rally.

BIDU is by far the most important Chinese stock in the current rally and it seems to have caught the Shanghai Flu. The Shanghai Composite Index is the leading major stock market this year, far outpacing gains on other bourses, including the American exchanges. But it has been suffering a case of jitters the last three weeks pulling back to its 50 MA for the first time since the worldwide rally began in March. Worse, Friday’s action saw it break the 50 MA for the second day in a row and for the first time close below it.

The Shanghai Composite Index could merely be enduring a well earned respite. But if so we should expect to see a forceful rebound from its current decline and Friday’s action doesn’t embolden a bull. As the leading index its fate will have important implications for markets worldwide.

What could be happening? There exists the possibility that the “China rapture” currently bolstering world markets is an empty pile of promises and the markets are coming to that realization. There has been plenty of euphoria over the resilience of the Chinese economy and the expectation that it will lead the world in recovery and perhaps in the future. Western liberals are in awe of the supposed success of a command economy in a way we haven’t seen since economist Paul Samuelson declared in the 70’s that the Soviet model was superior to the West’s because it could more efficiently direct resources.

Lost on observers are all the flaws inherent in such an economy which, because of the controls on it, doesn’t have the ability to self-correct. China has launched a stimulus that has thus far boosted growth and it has the resources to self finance that stimulus and make it ongoing. But the stimulus focuses mainly on lending to state enterprises, which are notoriously inefficient. The ability for the Chinese economy to continue to absorb this type of spending has not been questioned although we know from recent experience that these ongoing misallocations of resources can have disastrous consequences as we saw with the government encouraged American mortgage market.

Despite all the stimulus induced growth China remains an economy that is heavily export dependent but the United States isn’t coming back quickly as the major growth driver. Even when the US recovers its consumers will not have the balance sheets to revive the economic model on which China launched its growth curve. There is brave talk that China can focus on exporting to African and South American markets which are not as deep a well as the American market but supposedly broader because they encompass so many more people, but this is fantasy. Selling manufactured goods to people that cannot afford them isn’t a valid strategy no matter how many of them there are.

Part of the worldwide market rebound this year has involved a bounce in resource stocks, induced by what seemed to be China’s insatiable demand for raw materials. But there is emerging evidence that China was simply hoarding resources, restocking during a period of light demand in order to avoid the sharp price increases their outsized demand has caused in the past during periods of significant worldwide growth. Now that they have restocked demand could fall precipitously.

Is it reasonable to extrapolate all of this from one afternoon’s trading weakness in a Chinese stock? We don’t like to “think” too much or overtrade during a market rally. But when leading stocks suddenly stop leading we also believe it’s important as a trader to anticipate when a trend can start to move against you and what could drive it. It doesn’t have to happen but the pieces could well be falling into place. We don’t advocate nervous trading habits but we don’t believe now is the time to allow positions with strong remaining gains to move against you.