Will the U.S. Stock Market Continue Following China's Lead?

Dec.28.10 | About: iShares China (FXI)

The chart below shows the relative performance of the U.S. stock market (pink line) vs. the Chinese stock market (black/red line). As you can see, for the most part, the two markets have moved pretty much in tandem with one another. That is, when the Chinese market began to move lower, the U.S. market would also succumb to weakness.

[Click to enlarge]

But if you look at the far right hand of the chart, you will see that this relationship has began to break down recently. To recap, Chinese stocks have been weak recently amid fears that the government would have to tighten monetary policy more to cool the economy and deal with creeping inflation. Two days ago, the central bank raised rates another 25 basis points to 5.81%. This caused the Shanghai index to lose 1.9% in the following session and another 1.7% last night. The index has now closed just below its 200-day average as well.

So the big question now is, will the U.S. stock market follow suit, and turn lower in the immediate future? Or has this normal relationship begun to decouple, and will the U.S. continue to move higher without playing follow-the-leader in regards to China?

There are certainly plenty of red flags in China; namely, the huge property bubble -- from which it looks like the air is beginning to escape. China's property stock index fell -3.5% last night, and is down -28% ytd. Engineering a soft landing is a difficult task, and China's government has less experience in this endeavor than some other more developed nations.

For the record, we have sold all of our direct China exposure (FXI), although we still hold various International funds. I think in the intermediate term, the two markets can decouple and the U.S. will likely outperform China for awhile. The Chinese government has huge incentives to keep its growth engine humming, so I won't rule out returning to its markets longer-term -- but right now I see formidable headwinds.