China Stocks: From Bubble To Bear Market

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Includes: CN, FXI, GXC, MCHI
by: Daryl Montgomery

Summary

Chinese stocks were in bubbles in 2007 and 2015.

The drop in the last bubble was 72%, and it's at 49% so far this time around.

The long- and intermediate-term charts are bearish, and more downside should be expected.

Stocks in China were in a major bubble in 2007 and then experienced another bubble in 2015. Last time around, it took a little more than a year for the sell-off that followed the bubble to hit bottom. The Shanghai Composite lost 72% from its peak price of 6092 in October 16, 2007 to its low of 1718 in October 29, 2008. The selling was cut short, however, by extraordinary measures taken by the Chinese central bank and financial regulatory authorities to stop it. Prices in major stock bubbles can fall much further than this and for a much longer period of time. The most recent Chinese stock bubble peaked on June 12, 2015, nine months ago, and the drop from peak to trough has been 49% so far.

It's not that China hasn't taken significant measures to stop stock losses this time around, including arresting 197 people in late August 2015 for spreading online rumors. Prior to that, China vowed to arrest "malicious short-sellers." Stock trading was halted multiple times when stocks began to plunge and it was made illegal to short many stocks. Major stockholders were banned from selling stakes in public companies. As usual, more liquidity was pumped into the market, the cause of the bubble in the first place. The authorities finally stabilized the market in late August, but it had more than a 40% loss by then. A new wave of selling took the Shanghai Composite to lower lows in January.

Based on the long-term charts, it doesn't look like the most recent stock bubble in China has fully deflated yet. Below is a 10-year monthly chart showing both the 2007 bubble and 2015 bubble. Other than a precipitous rise and decline in prices forming a steeple-like pattern, the markers for a bubble are the RSI indicator moving significantly about 80 (circled in each case) and the D+ (NASDAQ:BLUE) line on the DMI at the bottom of the chart reaching 60 (red line above). Both of these indicate that the bubble in 2007 was much worse than the one in 2015 because the RSI was above 80 for considerably longer in 2007 (approximately a year) and the D+ line hit 60 twice, not once. The steeple price pattern was of course much higher and broader in 2007 as well.

There are two other important things to notice in the price part of the chart. Current price is resting on the 40-month moving average (the red line with the red arrow pointing to it). This is a key support for the index. Any break below this and prices could fall much further. Even more important, the 10-month moving average (gold line) is about to fall below the 20-month (blue line) moving average (the top red arrow points to this). This is a very bearish signal. On the left of the chart, a red arrow points to when this happened in 2008. Prices fell much lower after that occurred.

While the long term looks precarious for the Shanghai Composite, the intermediate charts don't look good either. The three-year weekly chart below shows the same bubble marker with the RSI having been above 80 for an extended period (circled in red) and the DMI trend (black line) having been around 60. The three indicators are all bearish, with the RSI below 50, the MACD below zero and the DMI on a sell signal (the red D- line is above the blue D+ line and the black line is rising). The moving average pattern on the price part of the chart recently gave a sell signal with the 40-week (blue line) moving below the 65-week (red line).

Moving average crosses are very helpful in determining when a market has turned from bullish to bearish (and vice versa), but lag the event considerably with a bubble, so they only appear later in the downturn. The classic pattern for a bear market is the 65-week above the 40-week above the 10-week. The 10-week falling below and staying below both of these moving averages predicts that this pattern is likely to form. This occurred in the beginning of January for the Shanghai Composite when a new move down in the index began.

The short-term daily chart shows similar bubble markers. There are ever so slightly bullish patterns on the RSI, MACD and DMI technical indicators (moving up in the case of the RSI and MACD, while price is moving sideways and DMI trend line weakening). This rally, if it occurs, would not likely last long and wouldn't alter the long-term bearish profile of Chinese stocks. It should be noted that the 200-day (40-week) hasn't yet fallen below the 325-day (65-week) moving average, but this sell signal is mathematically inevitable.

It should be assumed that the Chinese stock market is bearish and likely to fall further over the next several months. This, of course, could be interrupted by small rallies, but the overall down trend will still be in place for some time. In general, most investors should avoid this market for now. More aggressive investors could consider trading brief up moves or shorting at opportune times. ETFs such as FXI, MCHI, GXC and CN represent Chinese stocks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.