Investors in China Should Now Be Thinking Long-Term

The benchmark Shanghai Composite Index is in the midst of some selling after trading at a record high of 2,994.28 on January 24, 2007, up 142% from its 52-week low of 1,238.16 in March 2006. The selling was led by blue-chip stocks and was triggered by comments concerning the rapid rise in the index from the Shanghai Stock Exchange and other regulators.

The fear is that the rapid rise of stocks could lead to a bubble, which Chinese authorities clearly want to avoid. Cheng Siwei, vice-chairman of the National People’s Congress, believes a stock market bubble is in the works. Attempts are being made to cap the upside through the use of new capital gains taxes and other measures.

Looking at the chart, the 12.76% selloff from the high represents a minor correction, but we will not consider it a market reversal unless we see a reversal of about 17% from the peak (down to about 2,485). Should this happen, it could signal a trend reversal and further losses.

It is clear that there is mounting uneasiness amongst investors and institutions to lock in some profits due to the overbought condition of the Chinese market. If this selling intensifies, we could see a mass exodus out of Chinese stocks leading to a market reversal.

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At this juncture, watch to see if the Shanghai Composite Index can hold at 2,485. Given the failure to stage a break at 3,000, the index may languish in the near term until it can shake off the majority of sellers and attract new buyers.

On the Shanghai Composite Index, the Relative Strength Index (RSI) is declining and is weak. The index could see further weakness until the situation becomes overbought. We are not there yet. The MACD has also turned bearish and supports the recent correction from a bearish double-top formation. The break below the 20-day moving average at 2,824 is bearish. Watch for the index to hold at the 50-day moving average of 2,493 or we could see a trend reversal and more weakness.

Whether we see more downside weakness or not, I remain longer- term bullish on China.