Stock Markets: Two Canaries Calling For Caution
Over the past few days I have often referred to stock markets being overvalued on fundamentals, overbought on technicals and overbullish on sentiment. This resulted in my call for caution until such time as the risk/reward ratio adjusted to more favourable parameters.
Following investors' concerns about China's policy response to inflationary pressures of higher interest rates and tighter credit conditions, the Shanghai Composite Index this morning declined by a further 2.9%, making the cumulative loss since the November 8 highs 15.3%. The Index is trading solidly below its 50- and 200-day indices and is mapping out a pattern of lower highs and lower lows - pretty ominous.
Source: StockCharts.com
I will comment further on the Chinese PMIs over the next few days, but just want to alert you to the fact that the Shanghai Composite Index historically leads the Chinese PMI by about a month and is probably pointing to a weaker PMI in January - precisely what I have been warning about regarding seasonality and the influence of the Chinese Golden Week.
Source: Plexus Asset Management; I-Net Bridge.
My concern is that, just as we experienced at the trough of the credit crisis, China, India, Brazil and some other countries are again leading the rest - this time by tightening first in reaction to the inflationary pain created by global money printing before these conditions spill over to the U.S. and Europe.
In the meantime, a few stock markets such as Germany and Sweden yesterday gave key day reversals, with the U.S. markets showing a serious deterioration in breadth. Also, American small caps dropped by twice as much as the S&P 500 to indicate relative weakness in this economically sensitive group (see relative strength chart in bottom section below). Small caps often lead the broader market at turning points.
Source: StockCharts.com
China and small caps - are these the proverbial canaries in the coalmine? I suspect so, especially given the overvalued, overbought, overbullish condition of stock markets. I guess it is safe to say that the odds of a pullback / correction are pretty good, hence warranting extra caution, including tight stops and taking long positions on volatility with instruments such as VXX and VXZ (iPath S&P 500 VIX Short-term Futures ETN and Mid-Term ETN) to capitalise on "risk off" sentiment.
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Author: Prieur du Plessis
Dr Prieur du Plessis
investmentpostcards.com
With 25 years' experience in investment research and portfolio management, Dr Prieur du Plessis is one of the most experienced and well-known investment professionals in South Africa. More than 1 000 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns. He also published a book, Financial Basics: Investment, in 2002.
He holds the following degrees: BSc (Quantity Surveying) (Cape Town), HonsB (B & A) (cum laude) (Stellenbosch), MBA (cum laude) (Stellenbosch); and DBA (Doctor of Financial Management) (Stellenbosch).
Prieur is chairman of the Plexus group of companies, which he founded in 1995. Previously he was general manager: portfolio management at Sanlam, responsible for the management of investment portfolios with total assets in excess of $5 billion.
Plexus is a pioneer in the mutual fund industry and has achieved a number of firsts under Prieur's leadership. These include the authoritative Plexus Survey, a quarterly analysis of the consistency of the performance of unit trust management companies, the Plexus Offshore Survey, the Plexus Unit Trust Indices, and the PlexCrown Fund Ratings.
Plexus is the South African partner of John Mauldin, American author of the most widely distributed investment newsletter in the world, and also has an exclusive licensing agreement with California-based Research Affiliates for managing and distributing its enhanced Fundamental Index™ methodology in the Pan-African area.
In 2001 Prieur received the Santam/AHI Business Leader of the Year award for corporate leadership, business acumen and entrepreneurial flair. He was also profiled in the book South Africa's Leading Managers (2006). Plexus received the AHI/Old Mutual Enterprise of the Year award in 1997 and was also included in the book South Africa's Most Promising Companies (2005).
Prieur is 52 years old and lives with his wife, TV producer and presenter Isabel Verwey, and two children in Welgemoed, Cape Town. His recreational activities include long-distance running, motor cycling and reading. He belongs to the Cape Town Club, Johannesburg Country Club, Gordon's Bay Yacht Club and Swiss Social & Sports Club.
Copyright © 2008-2012 Dr Prieur du Plessis
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