Why Tuesday May Open With Another Flash Crash

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Includes: CHAD
by: Michael Munro

Summary

The Shanghai Index collapsed last night, with the vast majority of companies hitting their 10% max loss.

Due to the restricted nature of selling the Shanghai Market, this trend will likely continue tomorrow.

Since the North American market losses were ultimately triggered by the Chinese market collapse, I believe that the contagion will continue tomorrow.

Introduction

I just wanted to share my thoughts on the interesting events that unfolded this morning, and what this may mean for the markets tomorrow. It seems that the massive sell-off was triggered not by any major shift in the fundamentals, but rather a fear driven sell-off triggered by the collapse of the Shanghai market in China. I had written a brief article in the past on how to capitalize off a bearish Chinese market, and I would suggest reviewing this as it is relevant to this article. I am writing this article to briefly review the cause of today's crash, to suggest why it will likely continue a similar pattern tomorrow.

The Shanghai Index

It is important to be aware that the Shanghai index officially fell just under 8.5%, which doesn't necessarily mean the end of the world, right? However, this number is extremely misleading because no individual stock is allowed to fall more than 10% in one day. Therefore, looking at the huge number of stocks in the Shanghai Index, it seems that the vast majority of them hit the maximum 10%, many of them quite early in the trading session. What does this mean for the market tomorrow?

Logically, this means that the companies that maxed out their losses today, will likely continue their crash tomorrow. When I looked closer at the companies that did not fall 10%, they seemed to be some of the larger and more stable companies. Therefore it seems that almost the entire market fell the maximum 10%, with only a few heavily weighted exceptions. I think that this logically makes it likely for the North American markets to likely open at a large loss, much of which will likely be clawed back throughout the day. I think that it would be highly unlikely for the Shanghai index to match or break their 8.5% loss, but I believe it is very likely that the index will fall a few more percent. Given the extremely 'bubbly' nature of the Shanghai Index, I do not feel like I am giving a doomsday prophecy.

^SS000001 Chart

^SS000001 data by YCharts

The Short Term Short

I am usually not a short term trader, but I cannot miss a great short term opportunity with almost guaranteed returns. I believe that a great way to capitalize off of this continued decline is to purchase one of the Chinese bear ETFs that I mentioned in my previous article, with perhaps the best trade being Direxion Daily China A Shares (NYSEARCA:CHAD), which roughly corresponds to the inverse of the Shanghai index. Since I am extremely confident that the Shanghai index will continue to fall tomorrow, I purchased a small amount of this ETF this morning.

CHAD Chart

CHAD data by YCharts

What This Means For North American Markets

Since this morning's sell-off was triggered by the Chinese collapse, I can't help but wonder if a similar, albeit smaller, effect will occur tomorrow morning. I think it is reasonable that the Shanghai market will produce another day of losses, and I think that once again this contagion will spread to the rest of the world. It is no secret that the entire financial work is looking towards China right now, as they have been leading the world's growth for several years; any hiccup in this growth is leading to the fear that a worldwide recession could eventually be triggered by a faltering Chinese economy. I think that we can use this morning as a great example of what will happen in the future, as it seems the Chinese market is now exerting a greater influence on North American markets than ever before.

I won't get into the state of the Chinese economy in this article, as it has been covered very well in the past. I do want to remind readers that despite this massive collapse in China, it seems that the only major recent shift in fundamentals for China was a decrease in manufacturing output, which seems to have played a role in their currency adjustments. Like the Chinese markets, I have been saying for a while now that the North American markets are due for a significant correction (keep in mind, I was saying this when the Dow was above 18). I still believe that the US stock market is too expensive right now, and does need some more adjustments however the average P/E is not that bad right now in the US markets.

SPY Price Chart

SPY Price data by YCharts

Conclusion

I think that the Shanghai Index will continue with its downward momentum as the daily loss limits prevented investors from selling off all that they wanted to; it is only logical with the majority of companies selling off the maximum amount, will continue this trend tomorrow. I think the contagion will once again spread to the European and North-American markets, once again producing another drop. Discussing the depths of this drop and rebound seems speculative, but I am fairly confident that we will see a milder version of today, tomorrow.

Disclosure: I am/we are long CHAD.

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.