Chinese stocks and the Dow Theory
According to Zero Hedge, the Shanghai composite entered a bear market on June 24, since now it is down -22% from its February highs. Conventional wisdom has it that a bear market is signaled when stocks go down more than 20%. However, is it necessary for investors to wait so long (and endure the attendant drawdown) in order to be “sure” that a bear market sets in? The answer is no, as the Dow Theory gives as an earlier warning (which is on average -10% from the market highs, and much less in many instances as we have just seen with the US stock market last week when less than 5% was lost from peak to trough.
As the Dow Theory can be applied to foreign stocks as was explained in my post “Can Dow Theory be applied to foreign and to non-stock markets?”, which you can read here, I wanted to see if there was a way to spot a bear market in Chinese's stocks well before the mark of -20% were exceeded.
So I plotted the two charts that you can see below. The upper chart corresponds to the FXI ETF (which comprises 25 big companies). The lower chart corresponds to the HAO ETF (which is a small cap ETF). Please mind that I am applying "classical" Dow Theory (i.e. secondary reactions lasting 15 trading days, just two indices ).
The blue rectangles show the secondary reaction against the primary bullish trend. The red horizontal line highlights the secondary reaction lows, which, in case of their joint violation, would entail a primary bear market signal. As you can see the red horizontal line was violated on March 13, 2013, well before in time and in losses to the “official” bear market signal.
|On March 13, 2013, the Dow Theory signaled a primary bear market for Chinese stocks|
The closing high of the FIX was made on 01/02/2013 at 41.85. The violation of the secondary lows, and with it the primary bear market signal, occurred on 03/13/2013 at 37.34. So the FIX just lost -10.77% from its January highs.
In other words, had investors relied on the time-tested (and very logically aprioristically) Dow Theory rules, investors would have been forewarned with three months in advance of the beating that is now taking the Chinese stock market, and more importantly, would have protected their equity in a much more efficient way.
Enough for now. The evidence speaks for itself.
The Dow Theorist