Looking ahead...watch out for China

So, what's going to be the next "excuse" for the market to sell off? We've seen the market work its way through swine flu fears, Dubai fears, Obama bank regulation fears and now just recently Greece fears. All of the above provided excuses for the market to sell off, but because these fears do little the derail the recovery in earnings - the ONLY thing that really matters at the end of the day; they turned out to be just corrections. These types of one time exogenous events never derail bull markets. What derails bull markets over 90% of the times are sustained tight monetary conditions that eventually squeeze profits and tips the economy into recession. You know such conditions are in place when there is an inverted yield curve. A lot of people point out the subprime blow up as the trigger to the collapse in 2008. That's true, but the pin the popped the subprime bubble was tight money.

For a few months now, China has engaged in "soft" tightening policies to nip the bud of what they believe is an overheating economy, namely in real estate. After seeing what happened in the US when a real estate bust turns ugly, I'm sure Chinese officials don't want the same thing to happen.

I use the term soft tightening because they haven't raised lending rates but rather they have been taking alternative measures to slow things down. I'm no economist but I believe what Chinese officials are doing is very savvy. They are taking preemptive measures to prevent a dangerous real estate bubble from developing. Such measures include raising bank reserve ratios, reinstating the business tax exemption period for pre-owned home sales to five years from two (which discourages flipping); increasing the minimum down payment developers must pay for land purchases and more.

Lending rates (i.e. interest rates) have always been the big kahuna when determining whether overall monetary conditions are tight or not. Since lending rates in China (and the world) remain historically low these "soft" tightening measures being taken by China shouldn't slow down their economy to the point where boom turns to bust but we could very well see signs of deceleration come spring or summer and that could spook the markets into dreading about a "double dip" recession. If we do start to see signs of deceleration in China commodities would likely drop very sharply.

The message of the markets suggest that I could very well be correct in believing that China may start showing visible signs of a slowdown in the near future. The Shanghai Comp and the Hang Seng are both looking rather weak given the strength in the global markets as of late. In fact, they have been showing relative weakness vs. the US and European indices since mid July and especially since December. As the world markets have been making or are close to making new 52 week highs last week, the Shanghai and Hang Seng are still below their 52 week highs 13% and 11% respectively. That Shanghai actually peaked way back in July. If there's anything to pay attention to and worry about it's not Greece or some other one off... its China. Remember, at the bear market bottom last March as the US and European markets were making new lows, the Chinese markets made a higher low showing significant relative strength which turned out to be a leading indicator. Now China has failed to make a new high while the rest of the world is. Could the Chinese market be a leading indicator again to the downside this time? I think yes, but only for the IT term.

So how worried should we be about a China slowdown? Not much at this point but enough to be on guard for another scare in the market sometime in the coming weeks/months. Given that earnings momentum is strong on the upside with monetary conditions still very favorable all over the world, as China slows the rest of world should be able to pick up the slack and it's likely any Chinese moderation in growth will be just that....a moderation unless they raise rates substantially and any China related weakness in the markets would again prove to be just a correction in an ongoing bull market. Even if China ends up having a hard landing the rest of the world may have very well recovered enough to handle it. After all, China only accounts for about 7-8% of Global GDP (although a Chinese hard landing would likely hurt Japan too which accounts for 8-9% of GDP).

In early or mid 2008 I remember reading a foolish argument by bulls such as Ken Fisher about how a booming China was going to save the rest of the slumping world similar to how the US saved emerging markets in 1998 when they had a crisis. That argument was foolish for 2 reasons 1) China is too small to save the rest of the world and 2) China's growth is largely dependant on exports to the rest of the world which was hurting. Since that argument turned out to be bogus, then it must mean the opposite could in fact be true...that a slumping China could be handled by the rest of the world i.e. it wouldn't be enough to derail the prevailing positive growth trends in non-Chinese countries (except for perhaps Japan).

The bottom line is this....we're likely still in consolidation mode here even if the market manages to make new highs in the coming weeks. There's still potential for more worries in the weeks/months ahead and my best guess would be that a Chinese slowdown is going to be one of them. Such concerns would likely be short lived as per the reasons I discussed above. Here's another reason not to fear the end of this bull run - the advance decline line. It has made a significant new 52 week high last week which means that the breadth of the market is still very strong i.e. market is showing very good internal strength. During the topping process of a bull market (which typically lasts several weeks or even months), as the market makes new highs or retests previous ones it does so with less and less stocks participating. So, on the surface the market appears strong but internally it's deteriorating. It’s like meeting a gorgeous girl but then you realize she’s as dumb as a post and her hot body is the result of diet pills and semi-starvation.

With the market still strong internally, the yield curve still very steeply sloped and with so many amateur investors still LT bearish, aside from corrections, the odds of the bull market terminating anytime soon are close to nil.