An Unexpected Recoupling?

Nine days ago in this column we warned of a correcting Chinese stock market and expressed concern that the rapture over the Chinese economy’s ability to heal itself and drag the rest of the globe to prosperity could well be a chimera. Given that the rally in stock markets worldwide has been led by the Shanghai Composite this remains a real concern.

Since our column the Shanghai bourse righted itself and mounted a rally attempt. O’Neil has a superb method of monitoring the prospects for a rally. Simply put, after an index puts in a bottom and scores its first day of gains off that bottom it must be “confirmed” by a “follow through” on the fourth day or later with a significant gain on higher volume than the previous day. While this might sound unscientific it has a tremendous record of success in insuring that a savvy trader doesn’t miss a market turn while not wasting precious time chasing every feeble move higher.

The rally attempt began last Thursday. The Shanghai Composite continued moving higher Friday and Monday. Today, on the fourth day of the rally attempt and the first possible day it could be confirmed, the index suffered an ugly loss. At its low point it was down about 5% on the day. It recovered but still was off 2.6% for the session. Worse, the session featured higher volume than the previous day. O’Neil refers to this as a distribution day and his studies show that distribution so early in a rally attempt is usually a sign of impending failure and fresh lows ahead for the index in question.

All of this occurs as the reservations expressed in our prior column have been borne out. On Friday the Wall St. Journal reported that Chinese bank regulators are worried about indiscriminate lending on the part of banks, which have been encouraged to lend by stimulus money being pumped into the system. Regulators took measures to limit further lending which will slow the economy in the short term. The hope of course is to limit the buildup of bad loans on bank balance sheets similar to what occurred here in the States during the housing mania and became apparent only when the economy started to falter.

Then yesterday Chinese Premier Wen said that the economy faced difficulties due to the slowdown in exports to the US and that even given the stimulus it was difficult to boost domestic demand to pick up the slack.

With leadership from the Chinese market likely lost for now the question hanging in the air is if the American market can lead on its own merits as it has in the past. Our stock markets have seen repeated bouts of distribution over the last few weeks, mostly in reaction to weakness in China, but have thus far held their ground.

The buzz the last few years is how the emerging BRIC countries would decouple from the industrialized West and become the tail that wags the dog. While they are no doubt industrializing at an impressive pace, improving the lot of their citizens and bolstering the prospects for greater standards of living worldwide, the American dog, with its economy triple the size of China’s, just might wag the tail far longer than anticipated.