MARKETS SPECTATOR: Has the China slump been overplayed?

It's remarkable how quickly pundits have been to completely write China off. Whether we like it or, China is here to stay and will certainly be a major player in growth over the next 10 to 20 years.

We also must remember that China has been trying to slow their economy. That's right, they've been doing this on purpose to try and bring their exorbitant growth rates back to more sustainable levels. Unlike much of the developed world, they haven't lost complete control of their economy.

I'd be willing to bet that many G7 nations would love to trade positions with China right now!

It's well known that markets tend to move ahead of the economy and don't wait for the doom and gloom headlines to disappear before putting their money back in the game. Basically, markets are already pricing all this negativity in.

In fact, with the Shanghai Composite near three-year lows I'd argue it's a very crowded trade indeed, especially considering the valuations on offer.

To put these valuations into perspective, the price-earnings multiple for Shanghai A-shares is now below what it fell to in the months preceding the bull markets of 2005 and 2008.

Now there's no doubting that China is dealing with a number of issues at the moment.

However, pessimism levels seem to be getting close to extremes with the number of new stock broking accounts being opened grinding to a halt and China's consumer satisfaction index continuing to slip.

An extremely negative reading in sentiment often marks the low point, and as a result the turning point for an index. We are starting to see some stabilisation on the markets, an encouraging sign.

Source – Bloomberg

This chart and the one below it paint two differing pictures. The Shanghai Composite index is considered a very good indicator of domestic sentiment as it can only be traded by Chinese residents, of which about 70 per cent are retail. However, as you can see it has been in a clear downtrend and has only just managed to poke its head above the white downtrend line.

Source - Bloomberg

Now consider the Hang Seng China Enterprise index, which is a weighted market capitalisation index of 40 Chinese stocks listed in China. However, it trades on the Hong Kong exchange and is therefore freely tradeable globally.

When compared to the Shanghai Composite you can clearly see that it has been trading sideways since mid-May, forming what technical analysts refer to as a basing pattern (yellow box).

This is defined by Investopedia as a ‘period in which a stock or other traded security is showing little in the way of upward or downward movement. The resulting price pattern is basically a flat line. Often, 'basing' is a term used by technical analysts to describe an issue that is consolidating after a period of rapid growth or decline'.

More recently we note that is has decisively broken out above the green downtrend line and is now beginning to ready itself for what looks to be the start of an uptrend, which will be confirmed by a decisive move above the recent high (purple line).

Source – Stockcharts.com

The above chart confirms this theme further. It shows the outperformance of the Guggenheim China Small Cap Exchange Trade Fund (black line) over the Shanghai Composite Index (blue line). As you can see, the mainly smaller, higher-growth companies represented in the above ETF have shown excellent relative strength recently. This is seen as a positive sign and is much like the outperformance seen in the NASDAQ Composite Index prior to the 1980s bull market.

So, at times like this perhaps it's best to heed to some wise old advice from none other than the Sage of Omaha, Warren Buffett. ‘Be greedy when others are fearful and fearful when others are greedy'. The fears about China may be a great buying opportunity.