It’s hard to ignore a once-in-a-decade event. Snow in central Florida… A change in expression on Al Gore’s face… Like these unusual events, when something happens very infrequently, it commands our attention. And an event like this happened on Tuesday…
While America was sleeping, the Chinese stock market (Shanghai Composite) was in the midst of a brutal selloff that saw it dive 268 points (8.8%) by the end of the day. It was the largest single-day drop for the index since February 1997.
China’s plunge jolted other global markets. Traders across Europe reacted negatively, with the German, French and Spanish markets all slumping 3% and London’s FTSE-100 index down 2.3%. The major U.S. market indexes followed suit, with the Dow Industrials, Nasdaq Composite and S&P 500 down 3.3%, 3.9% and 3.5% respectively at the close today.
But here’s the big question: Is China’s slump the proverbial straw that breaks the camel’s back and sends the market into a corrective phase, or is it just a temporary hiccup in the third-longest bull market in stock trading history? More importantly, how should you react to this market swoon? Let’s take a look…
Chinese market sell-off: profit-taking or panic?
While the global markets sold off following China’s meltdown, the world hasn’t yet come to an end. Consider these facts about the Shanghai Composite Index that puts some perspective on today’s big drop:
• Even after the 8.8% spill, the Shanghai Composite is still up 3.6% in 2007.
• Including today’s fall, the index is still up an incredible 174% since its lows in the middle of 2005.
• China’s government made no announcements that triggered the fall, so there is no structural reason for a continued decline.
Most pundits have reasoned that the big fall was the result of profit-taking after the big run-ups mentioned in the points above.
But for me, the ‘profit-taking’ argument can always be loosely translated as: ‘We couldn’t find any other real reasons, so this is our last resort explanation.’ After all, an 8.8% single-day plunge would be some of the most rabid profit-taking in history.
Here’s the more likely scenario: Today’s events illustrate panic selling more than just benign profit-taking – and the warning signs were already there…
Chinese market sell-off: what goes up must come down
In a recent message, I wrote about the key market factors and warning signs that signal ‘topping behavior.’ For the U.S. markets, this includes:
• Record inflows of cash into mutual funds and exchange-traded funds.
• All-time lows in the Volatility Index (indicating a high level of complacency).
• An extremely long run in the current bull market (the third-longest in history).
The same logic applies to the Chinese market. Before today, it already had several fresh warning signs in place – and is extremely overbought. Even if the markets are going to head higher in the short or intermediate-term, they need some relief from overbought conditions.
In addition, the Chinese markets have a 10% limit for price drops in one day and a number of stocks hit that level today. This means that there could be some residual selling pressure in those stocks that didn’t reach their market equilibrium price.
The next two days will be critical for determining near-term direction.
Tuesday’s action means the markets traded below their monthly lows, so we’re now negative for the month of February. The key issue now is whether enough buyers come in to ‘save the month’ and put it back in the black, or if the pullback continues in earnest.
The pullback seems to be the most probable direction.
In your own portfolio, it’s vital that you honor your stops and keep your discipline. These steps are always a winning formula for long-term success.
By d.R. Barton, Jr., Quantitative Analyst, Mt. Vernon Research for the Smart Options Report, www.smartoptionsreport.com