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In our May, 2010 report on Leading Indicators of the Shanghai Composite, we illustrated that the decline in the Shanghai Composite from August, 2009 was more a function of the Composites weighting than a reflection on the Chinese equity market. Where the Shanghai Composite utilizes a unique capitalization weighting that favors large-cap stocks, the Equal Weighted Shanghai Index places more emphasis on smaller cap issues because all issues are weighted equally and there are many times more small and mid-cap companies than large-cap within the Shanghai Composite Index.

As we illustrated in the May report and in the chart below, most issues within the Shanghai Composite continued to advance up until April, 2010, while large cap issues peaked along with the Composite in August, 2009. The Equal Weighted Shanghai index tracked the S&P 500 and continued to show superior relative strength vs. the weighted Shanghai Composite.

click to enlarge image

Shanghai Composite & Equal Weighted Shanghai Index Daily

Our comments in that May, 2010 report were that

…a true downtrend in the Shanghai Composite should be preceded or accompanied by a downtrend in the relative performance line of the Equal Weighted Index vs. the Shanghai Composite. When that occurs, then the smaller cap stocks will have joined their larger cap counterparts in a downtrend, dragging the entire index lower. It is possible the April peak in the relative strength line is that top, but the relative performance trend has not yet confirmed that assumption.

As illustrated in the above chart, the relative performance of the Equal Weighted Index has weakened to such a degree that it is no longer in an uptrend relative to the Composite. This means that the smaller and mid-cap issues, a majority of the Composite construction, are now also in a downtrend and declining at a faster rate than their large-cap counterparts.

In brief; with a majority of the components of the Shanghai Composite now in a downtrend, and small to mid-cap issues declining at a faster pace, downside momentum is more likely to increase in the days and weeks ahead.

Disclosure: Author is short SPX, QQQQ

Source: Shanghai Composite: Downside Momentum Likely to Increase