I’m Shorting China And You Should Too
When it comes to stock markets, China’s sure marches to the beat of its own drum.
The Shanghai Composite gained 145% in the past year, compared to about 7% for the S&P 500. Now, though, things may be unraveling in China — and given what happened there just a few years ago, it is not likely to be pretty.
In the chart below, we can see the recent nearly vertical rise in the Chinese market after a slow, multiyear drift lower.
The same thing happened at the start of this century. It was as if sellers just gave up and buyers pushed valuations to impossible levels. Chinese stocks peaked in 2007 and then fell off a cliff when the magic of the Chinese economy faded, taking commodity markets down with them.
Experience shows that when a market trend continually accelerates, affectionately called “going parabolic,” the gain is often mirrored by the decline on the other side. Most of the time, the accelerated rally is erased completely.
If that happens again now, the resulting decline could be on the order of 55% to 60% from current levels — devastating by any definition.
Domestic investors cannot easily short the Chinese index, but they can participate in the decline via exchange-traded funds here at home. The most popular is the iShares China Large-Cap (NYSE: FXI), which has already lost more than 10% since its April high.
Normally it would be quite risky to sell an ETF that has already suffered what many would call a correction. However, that 10% drop is only a quarter of what FXI gained since last summer, and it has not even broken its trendline from that time.
So why sell something that is still officially in an uptrend? The answer is that the ETF achieved its upside target on the long-term charts and suffered a moving averages death cross on shorter-term charts.
In the above chart, we see a three-and-a-half-year trading range broken to the upside in March. The height of the range projected up from the breakout point yielded an upside objective that was reached nearly perfectly in April. Momentum indicators such as the relative strength index (RSI) started to retreat, and soon afterward, so did prices.
The ensuing decline took FXI below its key 50- and 200-day moving averages, and in May the short-term average crossed below the long-term average. This is known as a death cross and tells us that the trend has likely changed to the downside and to expect more weakness ahead.
The nearest support of any consequence is the top of the old trading range. Not coincidently, a quick drop to that level would also erase the accelerated portion of the short-term rally in FXI, just as the Shanghai Composite is expected to erase its sharp longer-term rally.
You may be wondering why these two charts look different. The first reason is currency exchange. But the real difference is that FXI tracks large-capitalization Chinese stocks that actually trade in Hong Kong. The chart of Hong Kong’s Hang Seng Index looks similar to FXI’s chart, and it, too, appears ready to fall further.
The bottom line is that the charts suggest selling FXI is a good idea. The downside potential to the first target might seem muted, but if and when the Chinese market starts to crumble, we can expect the ETFs connected with it to break support and continue even lower.
Recommended Trade Setup:
— Sell FXI short at the market price
— Set stop-loss at $50
— Set initial price target at $41 for a potential 13% gain in five weeks
Note: Please be aware that short selling is a risky strategy, but there is another way to play the downside that involves much less risk. At the end of May, my colleague, Jared Levy, saw the writing on the wall in China and predicted FXI would fall 10%. He recommended a trade that could turn that move into a 40% profit without risking more than $800.
He also turned a 13% sell-off in Yelp (NYSE: YELP) into a 40% profit without ever risking more than $395. And he made a 34% return in less than two months on Keurig Green Mountain’s (NASDAQ: GMCR) 11% slide with just a $1,390 bet.
You can learn more about his strategy and get his next eight trades without making any long-term commitment by clicking here.
This article was originaly published on ProfitableTrading.com: Flee This Investment Before the Bubble Pops