Chinese Market Riddle – Solved! (FXI, DJIA)

Riddle me this:

“Is it a lie…?
Or is it just the stock market?”

We offer a carrot slathered with Dijon mustard to anyone who correctly discerns what the above brainteaser is referring to.

And for those who haven’t a clue, we offer a second best – two celery sticks basted in lamb-gurney and a bucket of ice.

Turn to the cooking channel if you’re still in the dark.

pizza

Yichh!

 

Some basics:

The answer to the above riddle requires a minute’s explanation, and it goes like this –

Bull markets occur when there’s

1) an abundance of cash in the system that’s…
2) ready to be funneled into stocks.

Simple and true.

And bull markets stop rising when the money that’s available to the system either:

1) runs out or
2) is no longer willing to be funneled to said stock purchases.

And where are we now?

 

Today, we’re at a stage when the money is available – indeed, historically there has never been a time when so much liquidity was parked in the system awaiting its order to go a’shopping.

And as to the funneling – folks are actually starting to stream back into the market after a significant time away.

And yet the internals from the market are not so inspiring. We see examples every week of metrics indicating the market is overvalued, or that profits are flattening or that too many market participants are optimistic.

So what to think?

Before we answer that, let’s take a look at how Wall Street views the issue – and more importantly, what they do about it…

Bloat and Float

 

Wall Street is in the business of doing one thing and one thing only, and that is – watching the tide.

otis

If Wall Street discerns that there’s money out there and senses that it’s ready to buy, Wall Street finds a security (or creates one) to sell it.

On the other hand, as soon as Wall Street senses the tide is receding and the money is drying up, it begins to unload its holdings into the hands of those final few suckers who are entering the fray.

It then continues on its merry way, selling what it can while simultaneously offering guarded warnings about the purchase and sale of stocks in general and the potential for troubles ahead if earnings don’t keep apace.

In that way, it covers its bum.

cover

But in its essence – at its core – Wall Street is nothing more than a money-sniffing sales-offering animal without peer on the planet.

So, to return to our question above – what does Wall Street do when the money is out there and, like today, is still a little fearful of buying what’s on offer? When it still sees indications of overvaluation and contracting earnings?

What else? It expands the multiples.

What the…?

 

Consider an example.

If Freddy Kruger Nail Polish Inc. is selling at $100 with a P/E of 10, and the stock looks stuck, Wall Street has to find a way to get it moving. And the easiest way to do that is to make the stock worthy of a P/E of 14. This is what the street calls ‘expanding the multiples’.

And, of course, the analysts will be quick to argue that owing to its recent razor sharp growth curve and terrific branding, or its ability to slash prices and scare off competitors – whatever – Freddy Kruger has earned itself a higher value vis-à-vis its latest earnings.

Wall Street then raises its price target on the stock, and a whole new round of buyers are found to push the stock toward $140.

Miraculous.

Bull market.

Problem solved.

After all, the money was out there, it just needed a reason to come in.

So…

Is it a lie? Or is it just the stock market?

 

You decide.

But remember…

What really matters is the tide.

Which direction is it rolling?

And are you on the right side of the swell?

beaver

No, Wally. You didn’t.

 

As the tide swells, we turn our attention to a new trade.

And we introduce the matter with a very puzzling letter from an otherwise very straightforward gentleman and longtime reader named James, who recently wrote as follows –

“You use the Dow as a Market metric? Please spare me your twisted logic. The Dow is not representative of anything stock market wise. Perhaps you should try the S&P500? Or, better, the MSCI World? At the least, start studying something that at least represents the calamity you are predicting. jimo”

Odd, no?

We begin with a few facts (for those of us in need of a little study – ‘at least’).

YEAR S&P DOW
2008 -36.33% -31.69%
2009 20.37% 20.15%
2010 13.95% 10.13%
2011 1.54% 7.05%
2012 16.16% 9.70%
2013 28.39% 25.41%
2014 to date 13.34% 9.04%

The chart above shows returns from the beginning of the bull market. We include 2008 because a goodly number of issues bottomed at the end of that year – before the major market bottom of March, 2009.

In any event, you can see that the S&P 500 underperformed the Dow in two out of the seven years surveyed, was a dead heat with her in one year and outperformed in four. And how does that look graphically?

sp500128
Now, we won’t quibble with the fact that over the last seven years an investment in the S&P 500 offered an extra percentage point per year over the Dow (though to be fair, according to the above chart nearly all of that outperformance was acquired over the last twelve months). But to say the Dow is not representative of anything seems a far cry from the truth. Clearly, the negligible divergence between the two proves that the Dow is no less the juggernaut index it has been for over a century.

Speaking of Juggernauts…

 

This last month, China overtook the U.S. as the world’s largest economy. So it shouldn’t surprise reader James if we look to the Shanghai index, as represented by the iShares China Large Cap ETF (NYSE:FXI), to gain an understanding of which way markets are headed.

Shanghai before the MSCI World – that’s for sure.

And lo and behold, we see this –

fxi

Here’s a market that has been flying – 30% since the spring, and now trending comfortably above all her moving averages which unfurled neatly back in August (black box). We’re above both RSI and MACD waterlines (blue boxes) and half a buck from a major breakout (in red).

But it’s over the long haul that things are looking even more impressive.

Have a gander –

downtrend128

The longer-term picture shows a market that’s gaining steam, too.

And that’s good enough for us.

Break out the Dijon, Mario, we’re selling PUTs!

[mepr-rule id=”994″ ifallowed=”hide”][mepr-unauthorized-message][/mepr-rule]

[mepr-rule id=”203″ ifallowed=”show” description=”wall_street_elite_members_only”]

We’re going to pocket some cash by selling PUTs below support at FXI 37.

Wall Street Elite recommends you consider selling ten (10) FXI February 37 PUTs for $0.38 each, for a total credit of $380.

[/mepr-rule]

[mepr-rule id=”988″ ifallowed=”show” description=”executive_lounge_members_only”]

We’re going to pocket some cash by selling PUTs below support at FXI 37.

Wall Street Elite recommends you consider selling ten (10) FXI February 37 PUTs for $0.38 each, for a total credit of $380.

[/mepr-rule]

With kind regards,

Hugh L. O’Haynew, Senior Analyst, Normandy Research

Share your thoughts...

We encourage people to join in on the discussion. Please keep in mind however, that all comments are moderated according to our comment policy, and all links are nofollow. Let's keep the conversation professional and meaningful.