China at New Highs? Buy China! (FXI)

It’s all about China this week, as the world’s most populous country hints at a possible war with the United States – at the same time that its stock market soars to new highs almost daily and the possibility of an explosion on both fronts becomes clear to all.

Let’s begin with the delicate sounds of HQ-9 surface-to-air missiles exploding in the distance.

Last week China warned America of the inevitability of conflict if the U.S. does not stop its ‘meddling’ in the South China Sea. At the same time, China is conducting maritime maneuvers with Russia in – of all places – the eastern Mediterranean!

Now, whether the Chinese are readying for a conflict as a distraction for its stock market bubble popping, or whether the U.S. is readying the same as a distraction against a similar eventuality, is impossible to answer definitively. But certainly both could be true, and for China’s part, a pop in the Shanghai market looks much closer to imminent than something similar stateside.

The Shanghai Composite has advanced parabolically in the last twelve months, and completely out of proportion with any underlying economic reality or corporate growth prospects there, or on any planet known or unknown to space whacko Stephen Hawking.

The Chinese market looks like this –

SHANGHAI-COMPOSITE-MONTHLY-CHART

This is a monthly chart for the Shanghai Composite Index going back a decade. At the bottom of the chart, in blue, are monthly RSI readings for the index that show 1) just how overbought Shanghai stocks became through 2007 (before crashing), and 2) just how similarly overbought they are now.

The selfsame asymptotic trajectory that we witnessed then is now in play again (in red and black, at top), and the only question is when – not if – this market will do a repeat performance of its 2008 belly-flop.

RUB-THE-BUDDHA

We remind our readers that this is a monthly chart, that monthly overbought readings are an extremely rare phenomenon and that they rarely persist for the full year that Shanghai posted such readings nearly a decade ago (in blue, at left).

Shanghai–Hong Kong Stock Connect

We’d also remind you that it was a liberalization of the rules surrounding the purchase of Shanghai’s A-shares that triggered the wild buying frenzy of this last year – and that Chinese market authorities are preparing a new, looser share-purchase regimen for the country’s second largest market in Shenzhen for later in the year. The next phase of the so-called Shanghai-Hong Kong Stock Connect program will similarly allow foreign investors direct access to Shenzhen via brokerages domiciled in Hong Kong.

When that proposal becomes reality, we expect a renewed flood of funds to find its way into Chinese shares, pushing the indexes even higher into the overbought and toward their ultimate peak somewhere amid the thin cool airs of investment Shangri-la.

SHENZHEN-NEW-MARKET

All things considered, a wise investor might think it’s not worth it. After all, if the thing is going to crash, if it’s already parabolic and the monthly chart is way overbought, what’s the point?

And indeed, there’s an argument there.

But the approach might also be a tad simplistic, particularly in light of what’s happening in the rest of the investment world.

Consider the following…

The chart below shows the world’s leading markets and their respective price-to-book ratios against that of the S&P 500. And lo and behold, despite the Chinese market’s 100% gain over the last year, the data for that country are shocking.

Have a look –

PRICE-TO-BOOK-S&P

Of the eight large markets surveyed, only India’s is trading with a P/B ratio at a premium to the S&P 500. Both Shanghai and Hong Kong boast cheaper price to book multiples by as much as six tenths of a point.

And that’s phenomenal.

By this metric alone, investors would be wise to steer some portion of funds eastward.

But there are other indications that a Chinese pivot would be profitable.

Consensus forecasts for earnings growth in the world’s major markets over the next twelve months are charted below, and they indicate an expected 29% increase in profits for Shanghai stocks.

Have a look –

FORECASTED-GROWTH-SHANGHAI

Whereas analysts do expect earnings growth for the S&P 500 over the next year, it’s clearly muted vis-à-vis prospects for Shanghai.

The Doubters Step In

Some would contend that future earnings growth is an exercise in star-gazing and is about as useful as investing with a Ouija Board, and we have a lot of sympathy for those sentiments. But we also believe that not only is it different this time (fear grips us as we write those words), but truth be told, it’s very different.

GOOD-BUY-OUJAI

As we’ve stated many times before, this is a liquidity-driven global bull market that has become increasingly divorced from the underlying economics that once buttressed it. The whole ship of fools is floating upon a massive, and ever increasing tide of money that the world’s central banks are pumping into it, and it will not stop rising until one of three events occurs:

  1. Either those same funds get siphoned out of the system by the same central banks that dumped them there in the first place, or

  2. A general loss of confidence in fiat currencies ensues, or

  3. A major global conflagration ignites.

Take your pick.

Until we see one of those events, the market is going up.

And because China apparently still has more room to bubble-up than the United States – despite its already vertical twelve month climb – longer term prospects for that country may be superior to our own.

For that reason we would lean toward the speculative purchase of a very long-term CALL on the Chinese index, and the easiest way to play it is via the iShares China Large Cap ETF (NYSE:FXI), whose chart looks like this –

FXI-NYSE-CHART-RESISTANCE

Here’s what we’re going to do to capitalize off of this information –

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We’re going to buy the longest available FXI 51 CALL and sell some PUTs against it at FXI 44, precisely the point where long term support (in red) meets the rising 137 day moving average (in blue). FXI may slide somewhat in the near term, but the $44 line should hold.

Wall Street Elite recommends you purchase the FXI January (2017) 51 CALL for $5.20 and sell the FXI June 44 PUT for $0.22, the July 44 PUT for $0.48, the August 44 PUT for $0.81 and the November 44 PUT for $1.56. total debit on the trade is $2.13.

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We’re going to buy the longest available FXI 51 CALL and sell some PUTs against it at FXI 44, precisely the point where long term support (in red) meets the rising 137 day moving average (in blue). FXI may slide somewhat in the near term, but the $44 line should hold.

Wall Street Elite recommends you purchase the FXI January (2017) 51 CALL for $5.20 and sell the FXI June 44 PUT for $0.22, the July 44 PUT for $0.48, the August 44 PUT for $0.81 and the November 44 PUT for $1.56. total debit on the trade is $2.13.

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With kind regards,

Hugh L. O’Haynew

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