A Great Wall of Market Madness (FXI, DIA)

We’ve been watching the action in China and Hong Kong very closely of late, both on and off the playing field, so to speak.

The root cause of the latest rise in Chinese share prices can be directly attributed to the massive number of new accounts that have been opened after China relaxed its A-Share ownership rules.

But could anyone have foreseen the sheer volume of interest that such a move would generate? Could anyone have predicted the veritable tsunami of new cash that would splash into the Shanghai Share Palace?

Have a look here –

ACCOUNT-OPENING-RATES

Yeah, we know – you think we doctored the chart, or just made it up altogether…

No and no. Sometimes real life is stranger than fiction. And the money, too, is real, real, real.

Last week, 3,257,068 new A-Share accounts were opened! That’s right – in one week!

Phenomenal.

Know, too, that this is not the smart money, friends – no institutional cash here, no pension funds, just retail traders lusting after wealth, and using margin to get there.

The chart for Shanghai’s largest capitalization stocks, the iShares China Large-Cap ETF (NYSE:FXI), amply shows the results of all this new cash entering the fray –

FXI-SHARES-PRICE-RISE

The largest 50 stocks on the Shanghai Exchange bubbled higher by better than 50% in the last twelve months, including a 29% parabolic pop in just the last month or so (in red).

That spurred an overbought 80+ read on the RSI (in blue), a development that should shortly lead to a stern cooling of Chinese shares.

Whoa, Nellie!

The situation is clearly unsustainable, and Chinese authorities also recognize this. It’s possible that’s why they floated – then subsequently killed – a rumor regarding a transaction tax on all Chinese stock trades. The market sold off steeply that day as the rumor circulated, though it recovered some in the following session.

Still, the damage was done. The possibility of a levy on traders is now closer to probable, and we guess its implementation will be guaranteed if we don’t see some sideways to lower action in Shanghai in coming weeks. It’s inconceivable that a nation of central planners and jailers would permit a parabolic rise to continue until it exhausted itself. Every man-Jack knows that would lead to disaster.

Tax or Margin Call

There are any number of ways China’s economic planning bosses could cool the latest rise, and that includes a margin call of even a minute nature. A full 20% of all the trade on China’s market takes place with borrowed funds. A margin call would send a sharp spook through the system that would let everyone know the chill was on.

Either way you slice it, though, it’s advantageous to be thinking about a fairly firm cap now in place on the Shanghai stock exchange. And play it accordingly.

BUT-FIRST

We want to stress that the vast tides of cash now at play the system will roll to whichever investment locale is offering best hope for gains. Put another way, it means the global investment picture is now turning increasingly to one of momentum chasing, rather than anything that truly fits with common definitions of ‘investing’. Wall Street may drape an investment-looking cover over their stock picks, but the truth is they, too, are algorithmically programmed to hop on the latest volume induced rise of any stock or futures contract that’s on the move on any market of any country on the planet.

So if the Chinese decide to pull the wind out of the A-Share sails with talk of a transaction tax, the money will flee elsewhere. And because Europe and Japan are seen as less robust economically than our own 50 states, it’s more than likely the funds will flow here.

That, of course, will be predicated on a number of ‘ifs’, the first being a solid round of earnings beats this quarter from the S&P 500’s biggest and best.

See here –

PERCENT-OF-COMPANIES-BEATING-EARNINGS

So far, so good. We’re half way through the Q1 season and looking better than we have for four full years.

The second, as mentioned above, is continuing weakness in Europe and a cooling in Japan.

Europe may be a value play at this point, but we don’t expect the continent to attract momentum flows in the near term. We mentioned China already – up 30% in a month, but Japan’s been no slouch, either. The Nikkei has climbed 23% in four months and looks like it might be ready for a well-deserved pause.

STOCK-MARKET-CAPITALIZATION

The above chart shows how much increased market share the Asia Pacific has assumed in just the last year. China grew from 5% to over 10.7%, Hong Kong’s Hang Seng Index increased from 5.5% to 7.3%, and Japan grew marginally, from 6.9% to 7.1% – with the vast majority of those gains coming in just the last seven weeks!

Clearly, something has to give. As we stated on the chart itself, the pendulum should swing back imminently.

The American market has a great deal to commend itself (besides the above mentioned earnings reports). To wit –

  1. New highs after a fifteen year wait on the NASDAQ are generating interest globally.

  2. And the vigor of the technology sector – with Microsoft, Apple and Facebook all reporting outstanding results in the last week – has also renewed hope that a run higher for the indexes is now in the cards.

  3. The Fed rate hike is likely on hold for longer than had been anticipated, and

  4. Interest rates remain at their lowest levels in decades.

We therefore recommend that investors pair the U.S. market, as represented by the SPDR Dow Jones Industrial Average ETF (NYSE:DIA) against the iShares China Large-Cap ETF (NYSE:FXI).  This is a short term trade that anticipates American outperformance in the next eight to twelve weeks.

And we’ll use PUT options to set it.  How?  Here’s our plan –

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Options Trader Elite recommends you consider purchasing the FXI July 50 PUTs for $1.90 and selling the DIA July 170 PUTs for $1.87, for a total debit of $0.03 per pair traded.

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Options Trader Elite recommends you consider purchasing the FXI July 50 PUTs for $1.90 and selling the DIA July 170 PUTs for $1.87, for a total debit of $0.03 per pair traded.

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With love of the hunt,

Hugh L. O’Haynew

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