Another Reason Correction Could Be Shallow? China

Includes: IVV, PGJ
by: Michael A. Gayed, CFA

"Being defeated is often a temporary condition. Giving up is what makes it permanent." - Marilyn vos Savant

I noted earlier this month in a few tweets I sent out to followers of my company (@pensionpartners) the idea that the intermarket analysis I do suggested that the odds of a correction were at their highest level so far this year given some noticeable deterioration in the quality of leadership across and within various asset classes. Our ATAC (Accelerated Time And Capital) models went largely risk-off before jobs data came out which was weaker than expected. It appears as though the "Spring Switch" following the Summer Crash, Fall Melt-Up, and Winter Resolution, has not yet been activated. For those unfamiliar with the Spring Switch idea, it is my belief that a "switch" out of bonds and into stocks is likely to happen shortly by the retail investor in what I have dubbed to be the coming "Great Re-Allocation."

The most recent spurt of outperformance in Treasuries relative to stocks, the exact opposite of the Spring Switch, is in many ways the test for the entire thesis. There is seemingly a sharp increase in macro negativity, which is pushing back the bulls. I continue to believe that 2012 is likely a year of reflation similar to 2003/2009, and that in the event that the the correction I believe we are now in is indeed shallow as I have been stressing in my recent writings, then it will only embolden the bulls into risk assets.

I wanted to show one reason in particular I believe the correction could be shallow, and it is something I have alluded to before - the return of emerging markets. I have noted before the divergence of emerging markets to the U.S. in March which were likely in their own mini-correction as the U.S. plowed higher into the end of the best first quarter for risk assets in many years. With the spotlight now specifically on China because of weaker growth than expected and the recently announced doubling of China's currency trading band, I think it is worth exploring the idea of China now outperforming in a wobbly U.S. stock market.

Take a look below at the price ratio of the PowerShares Golden Dragon Halter USX China Portfolio (PGJ) relative to the S&P 500 (IVV). As a reminder, a rising price ratio means the numerator/PGJ is outperforming (up more/down less) the denominator/IVV.

We can see the strength that occurred in January as China led the U.S., the flattening out in February, and weakness in March which sent the price ratio to new 3-year ratio lows against the S&P 500. Notice however the most recent period of strength which appears to just be getting started. The implication is that China may now be on the verge of outperforming.

This likely would provide a bit of a buffer underneath broader equity averages, since strength in the world's exporter of supplies implies a pickup in global growth for those goods, which itself is a bullish indicator. So while we may be in a correction here in the U.S., strength in China's markets could dampen any kind of global hiccup in the broader reflation theme and trend higher.

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