Buy China or Sell U.S.? Shanghai, U.S. Stock Markets Diverge

Traders looking to Shanghai as a leading indicator for U.S. markets notice a divergence between the markets

Chartists and non-technical market observers alike have noted how closely the U.S. and Shanghai markets have tracked one another over the past two years. The Shanghai market took off a few months before U.S. stocks started climbing in March 2009; Shanghai also fell before U.S. stocks reacted to Europe’s sovereign debt crisis back in April. In short, Shanghaihas been a powerful leading indicator for traders.

Now, a wide and growing divergence in the two markets since November — the S&P 500 is up 13% and Shanghai is down 13 % — has market watchers wondering: Is the U.S. market about to crash? Or is Shanghai ready to rise again?

(A third logical possibility would be an end to their convergence. Financial blogger Joshua Brown makes this case, but even he considers it unlikely.)

For nuanced perspective on this key question as we head into the new year, we asked Frederick Jiang, portfolio manager of the Ivy Pacific Opportunities Fund (IPOAX).

By way of background, Jiang (left) confirms the correlation in the direction of the two markets, but points out an important difference in the magnitude of their moves. For example, while the two markets moved up and down together in 2009, Shanghai went up 83%, well more than three times the S&P 500’s performance.

In any event, Jiang is firmly in the camp that the two markets will re-converge through a rise in Shanghai. While the U.S. is the world’s most important economy, China is the engine of world economic growth, he says. When the world’s second largest economy is growing at a 10% rate and U.S. growth might reach 3%, the math indicates that China is the key swing factor in setting the market’s pace.

So, why the current divergence? Jiang cites two technical

 

reasons: First, investors in Shanghai made a lot of money in 2009, giving them much more reason than U.S. investors to take profits. Second, Chinahas more of a macroeconomic policy-driven market. The government has been fearful its rapidly growing economy might overheat, leading to inflation. It therefore has hiked the required reserve ratio, meaning that financial institutions have to reserve $17 for every $100 in new deposits.

Investors are now waiting until these government tightening policies run their course. We’ll know they have when inflation comes down from its current 5% to 4% or below. Jiang expects Shanghai to take off again in the latter half of 2011.

While China’s central bank continues to mop up liquidity, investors are eyeing double-digit earnings growth and an average P/E ratio of just 12 for Shanghai’s top stocks.

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