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We Need To Understand The China Situation image

Good morning. Well, here we go again. Just when you thought the market was focused primarily on oil, the game changes. Make no mistake about it fans, China is now front and center and it is important to understand what the heck is going on over there.

Let's start with the latest update on the Chinese stock markets. For the second time in just four days, Chinese stock markets were forced to close early on Thursday - and in record time on Thursday. The CSI 300 index fell 5% in first 13 minutes of trading, which triggered a 15-minute trading halt under the circuit breaker rules, which by the way, are new.

As expected, the losses mounted after trading resumed, and the index quickly was down 7%, a level that mandates the close of the entire equity market for the day. The CSI 300 index finished down 7.2%, while Shanghai Composite lost 7.3% and Shenzhen Composite fell 8.3%. Yikes.

Why the Dive?

There are a couple issues at play in the Chinese markets. But first, I'd like to point out that according to a report I read recently, there are 97 million people trading stocks in China - none of which have experience of more than a decade. Thus, the recent swoon is a relatively new phenomenon and you can bet that emotional selling is becoming part of the game now.

Turning to the areas of concern, obviously the economy is an issue investors are struggling with. It is no secret that the manufacturing sector has been in decline for some time now. The fear is that things may be weaker than publicized due to China's data flow being suspect at best.

Then there is the yuan, which appears to be the primary problem this week. In short, continued yuan weakness is a widely cited driver of the selloff in equities.

Is the Yuan Out of Control?

Here's the deal. There are two markets for the Chinese yuan. First, there is the mainland market, which is controlled largely by the People's Bank of China (PBoC). But then there is what is called the "offshore" market, which is accessible to all traders.

While the PBoC pledged to keep the Chinese currency at a certain level against the dollar after the August devaluation, the offshore market is thumbing its nose at the current peg.

The problem is that the yuan is falling to levels offshore that are well below the PBoC's target. For example, the yuan plunged to a five-year low on Wednesday as the spread between the PBoC's target (aka the mainland price) and the offshore yuan pricing hit the lowest spread since late 2010. And in short, this is not what traders want to see.

This situation is continuing today. Overnight, the PBoC fixed the yuan at 6.5646. In case you don't follow the levels of the yuan versus the dollar, this was down about 0.5% from yesterday's session and marked the biggest decline since the August devaluation. Oh and the absolute level was the lowest since March 2011.

In the offshore or "spot market" the yuan traded at 6.5906 to the dollar, which represents a spread of 3.96%. And the bottom line is this spread is not going in the right direction.

Why Do We Care About the Price of Tea (err, Yuan) in China?

There are three problems here.

First, there is the idea that China is losing control of both the yuan and the equity markets (and in turn, the economy). Which, of course, for a communistic country, is not a desired result. The key here is the potential for instability in the markets (check), the currency (check) and the economy.

Next, from a global macro point of view, it is important to recognize that a falling yuan is deflationary to the rest of the world. And with places like the U.S. and the eurozone fighting desperately to keep their economies moving ahead, well, a bout of deflation from China is not what the doctor ordered.

Then there is the fear over what is called "flight of capital." The point here is that when currencies weaken, money tends to leave investments in that country. Thus, the fear is that further declines in the yuan will lead to investors pulling money out of Chinese investments. And if one connects the dots, this is NOT what the Chinese stock markets need at this point.

U.S. Market Reaction

All of the above, when coupled with oil hitting new lows, the level of U.S. market valuations, weakening earnings, and a Fed that wants to continue to raise rates, means trouble for the U.S. stock market in the near-term.

So, with the market looking to open down hard once again this morning (futures are down more than 2% on the S&P 500), the question now becomes, how low will it go? Below are some key levels to watch for on the cash S&P chart.

S&P 500 - Daily

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However, it is worth noting that this does NOT appear to be an issue specific to the United States. I.E. there is no systemic mortgage crisis here! There isn't a massive pool of CDO's, CMO's etc. that threaten to blow up Wall Street banks. As such, traders will be on the lookout for a "washout" low that is emotional in nature. And with S&P futures down more than 40 points before the open, one could argue that the "washout" may soon be upon us.

In similar/past crises that were fear-based, the declines tended to be short and sharp and were then followed by a v-bottom, which has become the norm since 2013. However, the worry is that this time will be different and that a bear market may be upon us.

To be sure, I have been warning to be cautious on the U.S. markets for many moons now - even well before last summer's dance to the downside. In short, our long-term market indicators started weakening late last spring. So, while I personally believe this decline could wind up in the "bad news panic" category, a meaningful decline is not surprising to see at this stage.

But let's also recognize that stocks are VERY oversold at this point in time and that the U.S. stock market likes to "save the day" during these types of declines (a morning flush often reverses and surges higher). Therefore, I'd be looking for a spirited bounce in the near-term.

And finally, whether or not the current decline is the beginning of a bear market is a question for another day.

Publishing Schedule For 2016: With my Chief Investment Officer gig at Sowell Management Services (a registered investment advisor responsible for north of $600 million in client assets) comes a myriad of tasks and responsibilities, as well as frequent writing assignments, speaking engagements, video recordings, advisor calls/meetings, and industry presentations. Because of this, the time available to pen a "daily" missive is becoming more elusive (and nearly impossible when I'm on the road). And since my primary duty is to keep our investing strategies up to snuff and on the right path (or "out of the ditch" as William Sowell likes to say), my plan for the upcoming year is to publish my oftentimes meandering morning market missive two to three times a week - or when market circumstances dictate. For most, this will likely be a more appropriate diet of "Daily State" reports! But since there are loyal readers that will check in to make sure everything is okay in my world if I miss a day, I thought it would be best to publish my intentions for the "State of the Market" reports in 2016. Finally, I'd like to say thank you to all those who make this report a part of their morning routine. It is my sincere hope that readers will continue to find these reports helpful in some small way.

Today's Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    Japan: -2.33%
    Hong Kong: -3.09%
    Shanghai: -7.04%
    London: -2.71%
    Germany: -3.27%
    France: -2.58%
    Italy: -2.78%
    Spain: -2.48%

Crude Oil Futures: -$1.06 to $32.91

Gold: +$9.50 at $1101.40

Dollar: higher against the yen and pound, lower vs. euro

10-Year Bond Yield: Currently trading at 2.161%

Stock Indices in U.S. (relative to fair value):
    S&P 500: -37.35
    Dow Jones Industrial Average: -321
    NASDAQ Composite: -105.25

Thought For The Day:

Be not afraid of going slowly, be afraid only of standing still. -Chinese Proverbs

Here's wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
Heritage Capital Research

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of Global Growth
      2. The State of China's currency
      3. The State of Global Central Bank Policy

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 6 months, and long-term as 6 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Negative
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Neutral
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Neutral
(Chart below is S&P 500 daily over past 2 years)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Key Near-Term Support Zone(s) for S&P 500: 1990, 1950
  • Key Near-Term Resistance Zone(s): 2040-50

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

  • Trend and Breadth Confirmation Indicator (Short-Term): Negative
  • Price Thrust Indicator: Negative
  • Volume Thrust Indicator(NASDAQ): Negative
  • Breadth Thrust Indicator (NASDAQ): Neutral
  • Short-Term Volume Relationship: Negative
  • Technical Health of 100+ Industry Groups: Neutral

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • S&P 500 Overbought/Oversold Conditions:
          - Short-Term: Neutral
          - Intermediate-Term: Oversold
  • Market Sentiment: Our primary sentiment model is Neutral

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.

  • Weekly Market Environment Model Reading: Neutral

Indicator Explanations

Trend and Breadth Confirmation Indicator (Short-Term) Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates an All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year.

Price Thrust Indicator Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line's 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a "thrust" occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.

Volume Thrust Indicator Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -8.5% per year.

Breadth Thrust Indicator Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.

Bull/Bear Volume Relationship Explained: This indicator plots both "supply" and "demand" volume lines. When the Demand Volume line is above the Supply Volume line, the indicator is bullish. From 1981, the stock market has gained at an average annual rate of +11.7% per year when in a bullish mode. When the Demand Volume line is below the Supply Volume line, the indicator is bearish. When the indicator has been bearish, the market has lost ground at a rate of -6.1% per year.

Technical Health of 100 Industry Groups Explained: Designed to provide a reading on the technical health of the overall market, this indicator takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as "positive," the S&P has averaged returns in excess of 23% per year. When the model carries a "neutral" reading, the S&P has returned over 11% per year. But when the model is rated "negative," stocks fall by more than -13% a year on average.

Weekly State of the Market Model Reading Explained:Different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Market Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.


Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

David D. Moenning is an investment adviser representative of Sowell Management Services, a registered investment advisor. For a complete description of investment risks, fees and services review the firm brochure (ADV Part 2) which is available by contacting Sowell. Sowell is nit registered as a broker-dealer.

Employees and affiliates of Sowell may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or Heritage/HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

Advisory services are offered through Sowell Management Services.