First tripwire for market weakness

The Christmas Chinese rate hike took the markets by surprise and in ensuing sessions, the Shanghai Composite, which is shown below, dropped through important technical support as well as a Fibonacci retracement level.

There are a couple of good reasons why this could be the early signs of market weakness. First, China has been a bright spot of global growth and a slowing or worse, a Chinese hard-landing, would be highly negative for the world's economy. In addition, investor sentiment has been excessively bullish, which is contrarian bearish and makes stocks vulnerable to market weakness.


Intermediate term top or correction?
Given that commodity prices and cyclically sensitive stock markets, such as Australia, Canada and South Korea, remain in uptrends (see my previous analysis here), I am inclined to give the bulls the benefit of the doubt for now. Even if this were the start of a market correction, my base case calls for a minor pullback of 5% or so.

Were the markets to weaken, here are some signs that I am watch for to see whether this is just a minor correction or the start of a more serious downturn:

• How does investor sentiment behave? I will be monitoring the sentiment measures to see whether investors panic, which would be bullish, or if they remain sanguine and buy the dip, which would be bearish.
• What about China?  My base case is that China does not crash here. Here are three reasons why China won't experience a hard landing. I would also add a fourth, namely that the Chinese have sufficient financial reserves to mitigate the effects of a hard landing (for this cycle). Nevertheless, I would welcome signs of panic from analysts such as Mish, Andy Xie and others as signs of sentiment capitulation.


• How do the financials behave? A prerequisite for a financial crisis is the technical deterioration of the financials. The chart below shows the relative returns of the BKX Banking Index relative to the market. The Banks, after undergoing an extensive relative downturn, have actually begun to improve and outperform the market. This canary in the financial mine seems to be chirping quite happily.

I have written extensively about the macro risks to the global economy in this blog, but the problems of China, Europe and America are 2H 2011 stories, rather than immediate threats to the market. For the time being, I am still inclined that the intermediate term is up and any problems are more likely to manifest themselves as we move into the summer and fall.