Shanghai Composite Staging a More Spirited Rally Attempt

In Thursday’s session the Shanghai Composite sported a nearly 5% gain in strong volume. It was the third day of a new rally attempt. The index remains in a significant correction, having declined over 20% from its highs.

As we’ve explained previously, a market rally off an index low is generally only considered to have a chance of turning into a valid uptrend if it stages a considerable advance during a session (generally at least 1.7%) on an increase in volume no earlier than its fourth day off the bottom. We refer to this as confirmation. (For more details on this methodology see Paragraph 2 of our previous column, An Unexpected Recoupling.)

Today, in the fourth day of the rally attempt, the market tacked on a bit more than a half percent in lighter volume. By our metrics the rally remains unconfirmed but we feel it is intriguing.

The composite is rather insignificant in terms of capitalization and not a true representation of market values in China. Because of trading restrictions companies whose stocks are listed on both the Shanghai exchange as well as foreign bourses tend to have significantly higher valuations on the Shanghai market than the foreign exchange.

Why, then, do we follow it so closely and attach such significance to its trading action?

Because in the intermediate term activity in any market is as much psychological as anything else. Markets work efficiently over time, but their mechanics are to stage exaggerated moves in one direction and then another. And these moves have an underlying theme, whether it is the technology revolution (1996 – 2000 bull market), the belief that the technology revolution will not have the impact at first predicted (2000 -2002 bear market) or the race for perceived scarce resources (2003 – 2007 bull market).

The theme of the current investment arc, which has fueled the move off the March lows, is that China is an emerging behemoth that will lead the world to growth nirvana as it industrializes, lifts the standard of living of its huge population, and asserts itself on the world stage. Anyone who has paid the scantest attention to the history of economic development knows that this can be a painful and protracted process. This story line is unlikely to pan out as anticipated. But intellectualizing the market will lead you to trading failure. We embrace the markets’ broad arcs and try to profit from them.

And so we avidly follow the adventures of the Shanghai Composite, warts and all. The current move comes amidst news that Chinese authorities are trying to bolster investor confidence by expanding the amount individual institutions can invest in the stock market from $800MM to $1B. While this would ordinarily be a legitimate reason for bullishness the authorities have not increased the aggregate amount of foreign money allowed on the exchange. We therefore view any rally based on enthusiasm over these new regulations as suspect.

But it is not our place to approach the market with preconceived notions. We trade what we see and for now we wait to see if Shanghai can confirm its rally. Between now and the next US session on Tuesday there will be two trading sessions in China and we will follow them closely. If the rally confirms the odds are quite good that markets around the world will snap to and follow their leader to new highs. Alternatively should the rally falter we will become more aggressive on the short side as we anticipate a perhaps deepening correction.