Stock traders are always looking for red flags that could signal a downturn on Wall Street, especially when volatility picks up like it has during the past few weeks.
One place these traders often look for warning signs is across the Pacific in China.
China is important because, according to the CIA’s World Factbook, it is the largest economy on earth when measured by purchasing power parity, and it is still growing at an incredible clip.
In other words, in a global economy that is driven by consumption, China has the greatest capacity to consume everything from raw materials to finished goods.
This is why so many multinational companies are focused on expanding their business footprint in China. Who wouldn’t want access to a billion up-and-coming consumers?
However, while rapid economic expansion is a net benefit for China, it can also cause periods of volatility and uncertainty in the economy. This volatility often plays out in one of two ways in the Chinese stock market: over-exuberant buying bubbles and panic-laden fire sales.
China’s Economic Expansion
You can see extreme examples of both of these reactions in the weekly chart of the Harvest CSI 300 China A-Shares ETF (NYSEARCA:ASHR). Look at the massive jump in mid-2014 and the equally massive collapse in 2015.
The CSI 300 is to the Chinese stock market what the S&P 500 is to the U.S. stock market. It tracks 300 large-cap stocks on the Shanghai and Shenzhen stock exchanges. ASHR is an exchange-traded fund (ETF) that tracks the CSI 300. It is a convenient way to monitor and even trade the CSI 300.
When Chinese economic growth started accelerating in 2014, Chinese traders couldn’t seem to buy stocks fast enough. They seemed sure the market was going to go up forever.
Unfortunately for those traders, the bullish momentum didn’t last long. Fears of a potential slowdown in growth caused some traders to start taking profits off the table. Once a few people started selling, the panic set in, and the bull run collapsed.
Now, not all of the reactions in the Chinese stock market are going to be this severe. But because individual traders drive a much larger portion of trading activity in the Chinese market than they do in the U.S. market — which is driven primarily by institutional traders — swings in Chinese stock prices tend to be more volatile than the swings in U.S. stocks.
On a day-to-day basis, U.S. stock traders will watch for red flags signaled by strong short-term selloffs in the Chinese stock market. Those selloffs often carry over into the U.S. trading session, so they can warn traders ahead of time.
However, the more important red flags tend to develop over a slightly longer timeframe.
Searching for Red Flags
Looking at the comparison chart of the CSI 300 — represented by ASHR — and the S&P 500, you can see that the two indices tend to be fairly synchronized in their movements. They reach peaks and troughs at roughly the same time.
Interestingly, there are times when the CSI 300 will break through key support levels and start trending lower while the S&P 500 continues to move higher. This can be the cause of a more serious divergence between the two indices.
A divergence between the indices can serve as a warning that the economic forces pushing Chinese stocks lower may find their way around the globe and negatively impact the S&P 500 as well.
You can see an excellent example of this in mid-2018. The CSI 300 broke below support and kept falling through the third quarter while the S&P 500 continued to climb.
In October, the S&P 500 began to fall as well, and U.S. stocks officially entered a bear market.
The Bottom Line on Chinese Stocks
It has been a good week for the U.S. stock market so far, but we’re starting to see the formation of another bearish divergence between the CSI 300 and the S&P 500.
It’s important to note that a divergence like this isn’t a guarantee the S&P 500 is going to turn lower, but it does raise an important red flag.
The last time we saw a divergence like this, it took a few months before U.S. stocks started to fall. We don’t expect it to be any different this time.
We plan to take advantage of whatever bullishness the S&P 500 can still give us, but we’ll be more aggressive in taking profits off the table if it looks like bullish momentum is starting to fail.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.