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The big
X-factor for the stock market in the coming months will clearly be China.
During periods when any of the major weekly or yearly cycles are bottoming
and the market is vulnerable to a correction, there's always a news headline
event that serves as a scapegoat for the market's weakness. Last year the
scapegoat was Greece and the eurozone debt crisis.
This year the void will be filled by China's slowing economy.
Underscoring
the growing worries over China, Tom Orlik wrote in
the March 26 issue of the Wall Street Journal: "Markets fear a
slowdown in China's factories. They should also be concerned about possible
government instability." He went on to explain that China's real estate
investment showed no growth from a year earlier and that export growth
slipped to 6.8% from 14.2% in the fourth quarter of 2011.
Moreover, a
quarterly survey by China's central bank showed demand for loans at its
lowest since the financial crisis of 2008. The HSBC purchasing managers'
index registered a reading of 48.1 for March, below the 50 mark that
historically signals contraction and suggesting that China's manufacturing
sector is shrinking.
China's
economic slowdown was preceded by a major peak in its stock market in July
2009 after the post 2008 global market rally. China's Shanghai Composite
Index was the first of the major global markets to peak following the
post-credit crisis rebound, and it has been in a general slump ever since
(see chart below). Charles Dow, of Dow Theory fame, asserted that the stock
market typically discounts economic recessions by several months in advance.
In China's case its equity market was discounting an economic slowdown by a
couple of years in advance. This was due no doubt to the country's
stratospheric growth of recent years and the residual economic momentum which
kept its GDP forging ahead long after its stock market peaked. Yet the
downward trend visible in the Chinese stock market since 2009 was sending an
undeniable signal that leaner times were and are ahead for the country's
economy.
 
Illustrative
of the stock market's leading indication over the economy, ever since China's
equity market peaked in 2009, China's GDP growth rate has peaked and its
economy has slowed. This has also had a measurable impact on the global
market for commodities. Oil demand has fallen even though a number of
observers continue to attribute high oil prices to China's voracious appetite
for fuel. The International Energy Agency (IEA) recently noted that oil demand
has declined for the first time the global economic crisis of 2008. The IEA
blamed mild weather, high prices and the likelihood of a global recession for
the drop in demand, but a more likely culprit is China.
Gold and
silver demand has also been in decline since last year. The sluggish demand
is blamed by many traders on fears that China's formerly voracious demand for
metals may be waning, especially if its economy continues to slow.
China's
slowing economy can be attributed to the decision of China's central bank to
tighten liquidity. A series of interest rate hikes designed to cooling off
the runaway property market has had the unintended (or intended?) effect of
tamping down growth across the board. China has also increased fuel prices
for the second time in just over a month. According to Reuters, benchmark
diesel now costs about $1.22 per liter and gasoline $1.17 - about 20 percent
higher than average U.S. prices, and 50 percent higher than pump prices in
China three years ago. This is an extension of the tight monetary policy. And
while China's annual growth rate is still an impressive 7.5 percent, it
represents a slowdown from recent years. The fact that China's growth rate is
still high has lulled investors into a false sense of security. That still-strong
growth rate will be slowed even more significantly in the next year by the
heavy-handedness of China's political leadership.
Charles Dow's
postulate that an extended stock market decline sooner or later translates to
an economic downturn is instructive in China's case. The bear market for
China stocks is at least three years old (four if you count the pre-credit
crisis peak). The longer it persists, the more negative its implications for
China's industrial economy.
China's
cheerleaders made a critical lapse in judgment when they assumed the
country's runaway prosperity of the last 20 years signaled the birth of the
world's next super power. The clear lesson of history is that no nation ruled
by Communist leadership can ever hope to become a complete super power on the
global stage. An economy capable of bouncing back from adversity in short
order requires a flexible free market financial system able to respond to the
rigors and complexities of the reticulated global marketplace. A Communist
superstructure is by its very nature rigid and unresponsive to subtle free
market signals and can't help but eventually be overwhelmed by the economic
super cycles when they converge to the downside.
In many ways
this is China's first real test as a major economic power. The country will
soon discover what an industrial recession/depression is like. How it
responds to this critical test could well determine its economic and
political future. If the Communist Party proves woefully inept in responding
to the challenges of a deep economic recession, we may well witness a
revolutionary uprising of the Chinese people demanding a more democratic and
less authoritarian government. Throwing off the shackles of Communism would
indeed liberate China's economy, allowing it to reach heights previously
deemed impossible under Beijing's dictatorship.
The clearing
of the financial and economic landscape after the 120-year cycle bottom in
late 2014 will be, for many countries, the last chance for reform. China now
finds itself on the outer periphery of a spinning vortex of global
proportions - a whirlpool which will wreak havoc on the debt of developed
countries when it reaches its climax in 2014. The countries that will be in
the best position to assume leadership in the new 120-year cycle will be
those which have the lowest debt burdens relative to their productive
capacity, along with strong debt containment capabilities. China enjoys a
distinct advantage in terms of its sovereign debt. Its autocratic government
is a disadvantage, however, and could prove to be fatal to its long-term
economic designs. How China responds to its coming crisis will shed light on
its post-2014 future.
The coming
China super crisis could prove to be the touchstone issue of the final
120-year down cycle between now and late 2014. It would certainty take most
economists and asset managers by surprise. China is considered by many
observers to be relatively immune to the vagaries of Western style
deflationary cycles. Imagine their collective shock when they discover that
the Red Dragon isn't immune from the economic super cycles that have plagued
the West for decades. China has done an excellent job of copying elements of
Western capitalism into its state-controlled economy. But as Ian Bremmer recently observed in Reuters.com,
"Ultimately state capitalism is just a pale imitation of the real
thing."
Gold ETF
The iShares Gold Trust (IAU), our proxy for
gold, has been under selling pressure in the weeks since its Feb. 29 sell-off
and made a slightly lower low on Thursday, Mar. 22. As we predicted in our
commentaries of recent weeks, IAU has now tested the critical 60-week
(300-day) moving average shown in the chart below. As previously stated, the
60-week moving average has turned back declines in the past, including most
recently November-December 2011 correction.
IAU needs to
show us that it has bottomed, which it can do in the next few days by
re-establishing support above the technically significant 60-week MA, which
intersects at approximately the 15.60 level in the daily chart. A short-term
equity cycle is bottoming right now, which should take some of the pressure
off gold. Before we have confirmation that gold has made a bottom, however,
we need to see it confirm this bottom in relation to its dominant
immediate-term 15-day moving average per the rules of our trading discipline.
We remain in a cash position until this bottom is confirmed.
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