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Chinese Stocks Are In a Massive Bear Flag and This is How We Got Here

Chinese Stocks Are In a Massive Bear Flag and This is How We Got Here

James Stanley, Senior Strategist

- Chinese stocks took a massive drubbing this summer after a bubbling rally, and the declines sparked fear of a larger global slowdown around-the-world.

- Chinese regulators (along with numerous Central Bankers around-the-world) came in with statements or actions of support in September, and this stemmed the declines, for now.

- This has created a bear-flag formation in Chinese stocks that indicates that the pain-trade may not be over, but merely taking a pause after a jaw-dropping hit to end the summer.

China is slowing down. This should not be news, nor is this really up for debate. It’s pretty much an accepted fact at this point. But what isn’t known is how aggressively the economy in China is slowing down. Some analysts are anticipating a ‘hard landing,’ as years of credit excess may wreak havoc as the constant growth engine in China, industry, suffers massive declines. And then there are analysts that are expecting a ‘soft’ landing, with a much more manageable set of conditions that will allow China to continue its conversion to a more market-based, consumer-driven economy while offsetting the downward pressures that are to be expected with a contracting economy.

This all came to roost earlier this summer, as Chinese stocks began to take an absolute beating that eventually grabbed the attention of hedge funds around the world. But looking at the decline without the proper scope misses out on some much needed context, for these were all gains that were accumulated in the very recent past. The Chinese equity story really re-started last September, as Chinese stocks were trading perilously close to their Financial Collapse lows. The Financial Collapse was especially severe in China as stocks dropped by well over 70%. This dented investor confidence in the country, and from that point on there was a significant reticence of investors to jump into the stock market: Many Chinese investors just didn’t trust it. Instead, property was the investment vehicle of choice, and real estate prices continued their ascension until most Tier 1 cities were far beyond the point of affordability for the average Chinese resident.

Chinese Stocks Are In a Massive Bear Flag and This is How We Got Here

Created with Tradingview; prepared by James Stanley

But around September of last year as Chinese economic data was beginning to look grim, there were few places left to invest. So, with some encouragement from the government, Chinese investors began jumping into stocks again, and as is to be expected by anyone with a basic understanding of supply and demand, prices went up. And as prices went up, more investors were incentivized to jump in the market. And before you knew it, The Shanghai Composite (shcomp) was up by 50% in 5 months. Five months after that, we had another outsized move to bring the running tally to 100%: So Chinese stock prices doubled in 10 months.

This got investors really excited, and this is when people started to leverage their home equity simply so that they could borrow money in order to invest that in the stock market, on margin. This is when farmers or carpenters stop working in the trades they’ve been honing for their entire lives, because they see the promise of fast money in a bubbling market.

Two months later, that rally in the Shanghai Composite was up by 150%. The chart below shows this run, and notice how that Fibonacci retracement from the first chart continued to play out during as support and resistance during this most recent rally.

Chinese Stocks Are In a Massive Bear Flag and This is How We Got Here

Created with Tradingview; prepared by James Stanley

And as you can imagine, stock prices running up by more than 150% in a year has a tendency to change things. Not only do we see farmers drop the pitchforks in favor of the laptop, but we start to see the public get very interested in stock investing. This happened in the US during the tech boom when day-trading was all the rage. This is why I got into markets in the first place as an impressionable teenager, and this run in China surely did the same for other young, aspiring traders.

But just like the tech boom, this Chinese rally did not end well, and likely, the story isn’t over yet.

This summer presented a perfect storm for markets: Commodity prices were continuing to drive lower (with many pointing the finger at Chinese selling) while the Federal Reserve looked at the first rate hike in over nine years. We’ve spent much of the year bantering over ‘should they’ or ‘shouldn’t they,’ and meanwhile, the ground has been shifting beneath our feet the entire time.

Chinese stocks started to pop lower in June of this year, and like most retail-driven rallies, margin calls ensued as a simple-dip lower erased investor’s equity. Within 2 weeks, half of that incline was erased….

Chinese Stocks Are In a Massive Bear Flag and This is How We Got Here

Created with Tradingview; prepared by James Stanley

By August, this pain was starting to show around the world. An already vulnerable European economy could ill-afford to face pressure from the East, and with the United States in the midst of a fledging recovery, the threat of a ‘hard landing’ out of China was enough to create risk aversion around the world, and for a short time, it looked like a collapse was near.

But as has become normal over the past six years, Central Bankers rushed-in to markets in response. Chinese regulators enacted a slew of regulations designed to stem the declines, and Central Bankers across Europe and the United States started talking up ‘looser for longer.’ The really troubling part, at least initially, was that actions from China appeared to have little impact. As a matter of fact, in some cases it appeared to make the situation worse as it became obvious that the government was concerned. Just because regulators suspended IPO’s or cut interest rates another time (6 total cuts in the last 13 months), it doesn’t stop the margin call that joe farmer is getting on his brokerage account.

Eventually, selling pressure subsided as a global ‘risk-on’ rally ensued. For Chinese stocks, they were back to their bullish ways, at least temporarily, as SOME investors rushed back into the market under the presumption that regulators would continue catapulting stock prices higher. But not all investors came back, because just like 2008, many were burned by margin calls and simply don’t trust stock investing any longer. This means there are fewer possible buyers, and this also means that ‘lower-highs’ should be expected.

And that is what leads us to today… Chinese stocks have continued their run higher, but that rally is starting to slow down. And if we look at this rally with proper scope, we’ll see that this is a fairly standard retracement ahead of a large move lower. This is the ‘bear-flag’ formation, and this will often show up as a retracement in a down-trend. This was the same signal that traders could’ve looked to trade the EUR/USD break back in October (before the ECB disappointed), and this is a very valid way of looking for down-trend continuation. The chart below illustrates:

This rally is really just a bear flag. This situation isn’t yet over.

Chinese Stocks Are In a Massive Bear Flag and This is How We Got Here

Created with Tradingview; prepared by James Stanley

To trade the bear-flag formation, traders can wait for a down-side break before looking to run short. But given the macro-economic impact of a potential ‘hard landing’ in China – Japan may be a far more attractive area to look to play that theme, as we had outlined in yesterday’s Market Talk. Because while China may be in a troubling spot, Japan is along for the ride whether they like it or not; and given the sociological scope of these two economies, Japan is in a far more vulnerable position.

To play this theme – traders can look to buy the Yen under the premise that safe-haven flows will likely run through Japan should risk-aversion hit across markets. And with Japan having recently taken a $64 Billion hit when their pension fund invested in the stock market, it reasons to imagine that the Bank of Japan might be reticent towards doing another round or an extension of their easing program. The chart below illustrates the current setup on the Nikkie, and notice that we’ve just broken below a long-term, confluent zone of Fibonacci support that had previously held price action fairly well.

Chinese Stocks Are In a Massive Bear Flag and This is How We Got Here

Created with Trading Station II; prepared by James Stanley

--- Written by James Stanley, Analyst for DailyFX.com

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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