Monday, August 9, 2010

An unbalanced China bet?

I have been somewhat skeptical of the current stock market rally but I haven't quite been able to put my finger on the reason - until I looked at the market relative charts to see where the leadership has been coming from.

The downdraft that ended in early July was based on a double-dip recession scare. If Mr. Market truly believed that the recovery was real, then we should see leadership from sectors such as Consumer Discretionary stocks. The chart below shows the relative performance of the Consumer Discretionaries (XLY) against the market. The sector has been fairly flat against the market since early July, indicating that market leadership isn't coming from expectations of a revived consumer.

What about the Financials? This is a sector that has been badly beaten up since the Lehman Crisis and was in need of rescue. Did the Financials lead us up in this rally? A glance at the chart below says "no". In fact, Financials remain weak and in a relative downtrend versus the overall market.

If the leadership isn't coming from the cyclical consumer or beaten up Financials, then where is it coming from?

The answer is in Industrials, which is tilted towards capital goods:

,,,and the resource sector such as Energy (shown below) and Materials (not shown):

A Shanghai relief rally
Under more "normal" circumstances, a market rally would be predicated on a reviving consumer or a recovery in the financial sector. Instead, we have a rally led by hard assets and capital goods. Digging deeper, this rally tracks the rally in the Shanghai Composite, which bottomed in early July and is showing some signs of life.

This suggests that US equities are rallying based on the belief that China, which has been the last hope of growth in a growth starved world, isn't going to experience a hard-landing despite the bad loan risks in their financial system. In the meantime, indicators such as the ISM Manufacturing Index continue to weaken and so does the much watched ECRI WLI. While a soft landing in China may be a relief to investors, a scenario like that is highly unbalanced and does not provide the basis for sustainable global growth.

No comments: