Weak Hands Dropping Fragile China

05/24/2010 12:01 am EST

Focus: GLOBAL

Paul Goodwin

Emerging Markets Specialist and Analyst, Cabot Heritage Corporation

The selling in Shanghai signals more pain ahead for emerging markets, writes Paul Goodwin of the Cabot China & Emerging Markets Report.

We shouldn’t let the dramatic nature of [the recent] vertiginous free fall and [the occasional] equally disorienting recovery distract us from the main tendency of the current market, which is down. 

It’s good to remember what the market is actually doing right now, which is squeezing out the excess hot money that has been flowing into emerging market stocks over the past year or so. 

If you remember the flurry of stories about China that appeared like a dazzle of butterflies a couple of months ago, you can get a pretty good picture of what’s been happening.   

All of those “China Is the Place to Be” and “Here Comes China!” stories represented the final emergence of the China investment thesis into full public consciousness. And in the same way that the naming of Amazon.com founder Jeff Bezos as Time Magazine’s “Man of the Year” for 1999 marked the high point for the tech bubble, all that China talk in the latter part of 2009 marked a high for the past few months.   

Does this mean that there’s been a “China bubble?” Absolutely not. A bubble is a speculation that’s based on absent or inadequate value, like tech stocks with no earnings or mortgage bonds based on feverishly overvalued housing values.   

Since China has both growth and earnings, this correction counts as a boil-over, not a bursting bubble. 

The major trend of the Chinese market (as represented by the Halter USX China Index) began to flatten out in August 2009, when the index began a period of five months of trading under resistance at 5,600. A surge to 5,900 in January 2010 gave way to a steep correction, but the index battled its way back to 5,900 in April (with a three-week pause around 5,600 showing the power of that old 5,600 resistance level). 

After a couple of high-volume down days (April 16th and 27th), the index finally fell through the floor on May 4th and just kept on going, giving us the negative reading that’s now in effect. 

It’s worth noting, from a technical point of view, that the Halter Index has repeatedly found support at 5,000 (August, October, and November 2009 and February and May 2010).  It’s comforting to have that floor. 

But the index also notched a textbook double top at 5,900 in January and April. And as we all know, double tops frequently mark the end of up trends. 

So, what’s the bottom line for all this turmoil? Mostly it’s that the global equity markets in general and China in particular need a period of correction to shake out some weak hands. The surge of optimism that brought the most recent wave of hot money into stocks needs to cool. Then there will have to be a little more pain to discourage the enthusiasts and get them back on the sidelines. 

We’ve put most of our stocks on hold, and likely won’t recommend any new buying until the amateurs have been abused sufficiently to create new opportunities. 

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