In today’s ever-more interrelated financial world, China’s stock-market action is growing increasingly influential everywhere else.  As the globe spins, the results of each day’s stock trading in China often spill over into Europe and then the States to affect sentiment.  This impact is universal, but especially pronounced in sectors China plays a major role in like commodities stocks.

Interestingly, the recent breakdown in the US stock markets in late June was the latest example of this China-driven sentiment bleedover.  On Monday June 28th, the flagship S&P 500 stock index (SPX) in the States remained well above its correction lows from 3 weeks earlier.  But as China’s stock markets opened the next morning, a US non-profit organization released a downward revision in its brand-new index of leading economic indicators for China.  It claimed it had made “a calculation error” weeks earlier.

The reaction in Shanghai was fast and furious, China’s flagship Shanghai Stock Exchange Composite Index (SSEC) plunged 4.3% on Tuesday the 29th.  It was this index’s worst selloff by far in nearly 6 weeks.  Later that same day, this ugly Chinese sentiment spilled over into the States and drove a 3.1% SPX selloff.  Not only was this the worst US down day since just before the correction bounced in early June, but it drove the SPX to fresh new correction lows.  This led to more selling in the following days.

And when that “news” alleging a slowing Chinese economy hit, commodities stocks bore the brunt of the selling pressure worldwide.  If China’s economy was really slowing as the US non-profit that didn’t know how to properly build spreadsheets suggested, it portended lower commodities demand.  Since growth in China is often the prime mover in the global commodities markets, commodities-stock traders have to pay especially close attention to this maturing economic giant.

Just as the action in the US stock markets affects our collective economic outlook here, the same is true in China.  No matter where in the world they exist, when stock markets are weak people automatically assume this means the local economy is weakening.  And vice versa if they are strong of course.  So the fate of the Shanghai Comp colors expectations about China’s economic growth and hence its future commodities demand.  So often as goes Shanghai, so go commodities stocks.

Global stock-market sentiment is one big incestuous circle, so the SSEC often mirrors the SPX as well.  Consider the last cyclical stock bear that cascaded into late 2008’s infamous stock panic.  The SPX topped in early October 2007, and the SSEC followed about a week later.  The US stock panic climaxed in late November 2008, just a couple weeks after the SSEC slammed into its own nadir.  But as is often the case, Shanghai amplified New York’s moves.  The SSEC plunged 72% to the SPX’s 52% in that cyclical bear.

Interestingly commodities-stock performance over that span was much closer to the SSEC’s losses than the SPX’s.  Even most of the world’s best elite commodities producers saw their stocks plummet closer to 3/4ths than the general markets’ half here in the States.  The horrendous losses in Shanghai, and their implications for China’s future commodities demand, certainly played an important role in commodities stocks’ panic psychology.

And I think this is happening again today, the China-stock-market feedback loop depressing commodities stocks far more than was reasonable during the recent SPX correction from late April to early July.  Over this event where the SPX shed 16%, the XLB ETF (materials stocks in the SPX) fell 20%, the XOI oil stocks fell 22%, and elite market-darling copper miner Freeport McMoRan lost 26%.  Correction losses in smaller commodities stocks often ran between 33% and 50%!  It was a bloodbath for this group.

Such radically-oversold conditions always present big buying opportunities, so we have been aggressively layering in to new high-potential commodities-stocks trades.  And just as the China sentiment angle contributed to the recent sharp commodities-stock sell-off, it is likely to really amplify the commodities-stock recovery as well.  The charts in this essay reveal why.

This first one superimposes the Shanghai Comp over our usual benchmark SPX since early 2009, the period that encompasses the cyclical bull that emerged out of 2008’s epic stock panic.  The parallels between the Chinese and American stock markets in the last couple years are fascinating and illuminating.  Every investor and speculator playing in the commodities-stock realm needs to understand this important relationship.

Technically the classic stock panic ended in November 2008, that is when extreme fear peaked (87 VXO!) and panic selling exhausted itself.  That is when the Shanghai Comp bottomed as well.  The subsequent March 2009 lows (51 VXO) here in the US weren’t an extension of the panic, but despair lows driven by the Marxists who had just taken over Washington.  In February 2009 they were self-righteously declaring that we overtaxed American investors weren’t paying enough taxes to those thieves in Washington!

It was despair over these proposed massive new tax hikes on American investors courtesy of the newly-empowered Marxist regime that drove the March 2009 SPX lows in the US.  Since China didn’t face the same depressing regime change and resulting punitive tax policies that we weathered in the States, the SSEC didn’t follow the SPX to new lows.  Ever since then, the SSEC and SPX have usually tracked pretty closely.

In early 2009 emerging from Washington’s despair lows, the SPX and SSEC action mirrored nearly perfectly.  But last June, a big divergence developed.  While the US stock markets suffered their first material pullback of their young cyclical bull, the Chinese stock markets rocketed higher.  I can’t recall exactly what drove this particular SSEC spike, as last summer my attention was riveted to the US stock markets and commodities (which corrected too despite China’s strength).

When the SSEC peaked in early August 2009, it was up 64% since the SPX’s March 2009 lows compared to 49% for the SPX itself.  The SSEC had surged way ahead of the SPX, taking the bull lead.  And this was probably justified to some degree, since China had fallen much farther than the US in the preceding cyclical bear.  The bigger the loss in a bear, the bigger the recovery bull after it ends.  Still, the SSEC was starting to look parabolic last summer and couldn’t sustain such a blistering rate of ascent.

So it corrected sharply last August, plunging 23% over less than a month where the SPX rose 1%.  With this Chinese-summer-rally anomaly resolving itself, once again the SPX and SSEC were meandering together again for the rest of last year.  These indexes’ movements in the final third of 2009 are nearly identical, as you can see in this chart.  But in early 2010, a new divergence started to develop.

While Shanghai mirrored New York during the SPX’s pullback ending in early February, the biggest in the US cyclical bull to that point, China didn’t recover like the States did.  While the SPX immediately began climbing higher into late April, the SSEC lagged with an anemic rally.  The performances of commodities and their producers’ stocks were much closer to the SSEC’s sickly one than the SPX’s strong one.  This sector largely sat out the relentless SPX rally from February to April, really frustrating commodities-stock traders.

Though I watched this latest divergence develop, its cause wasn’t clear.  Unfortunately I don’t speak or read Chinese and thus can’t get a firsthand understanding of popular zeitgeist among Chinese investors regarding their views on their stock markets and their economy.  I suspect this all tied into Europe fears though.  As sovereign-debt issues in Europe magnified in investors’ psyches, everyone thought Europe was sliding inexorably towards a cliff.  And Europe is China’s largest export market, so a European implosion would hammer China.

Of course the Europe fears were way overdone, creating a euro panic that was likely a misinterpretation of the causality between the SPX and US dollar.  At any rate, when the SPX started correcting in late April right after the blowout that spawned that depressing Gulf oil gusher, the SSEC was already pretty weak.  Right before that correction when the SPX was up 80% from its March 2009 lows, the SSEC was only up 41% over this same span.  It was already languishing below its 200dma when the US correction started.

With all markets interrelated, the fearful sentiment in the States spilled over into China day after day.  The SSEC fell in concert with the SPX, but since the former started at much worse levels its correction was much deeper.  Parallel with the SPX’s 16% correction between late April and early July, the SSEC lost 25%!  Once again China, a far-riskier market than the States, amplified the moves in the American stock markets.  The result was the huge gap between the SSEC and SPX rendered above.

Just after the SPX bottomed again on Friday July 2nd, the SSEC followed it lower on the next trading day in China (Monday the 5th) despite the US markets being closed for Independence Day.  At its correction low, the SPX remained 51% above its March 2009 despair lows.  Yet the SSEC, incredibly, was just 12% above its own levels from that same day in March 2009!  While the US stock markets were very oversold, the Chinese stock markets were radically oversold.

All over the world, commodities-futures traders and commodities-stock traders view the state of the flagship Shanghai Comp as a proxy on the state of the Chinese economy.  And when you see how bad the SSEC has been faring lately, it is no wonder that commodities and commodities stocks have been hit exceptionally hard in the recent correction.  If commodities’ all-important marginal demand growth out of China is in jeopardy, the commodities’ secular-bull prospects dim considerably.

But what if all this mean reverts?  For most of their parallel cyclical bulls to date, the SSEC has tracked the SPX fairly closely.  There have only been two anomalies, and the first where the SSEC outperformed the SPX resulted in the SSEC dropping back down to track the SPX again.  And in today’s second anomaly, the SSEC has far underperformed the SPX.  So if it mean reverts the Chinese stock markets will rally dramatically, wildly outpacing US gains, to catch up with the SPX again.

As the Shanghai Comp soars, commodities traders around the globe will assume it reflects highly on China’s newly-awesome-again economic-growth prospects.  The commodities stocks that grew very oversold in the recent correction will rocket higher to reflect this radically different sentiment.  And as the euro rallies (driven by the US dollar) and Europe anxiety fades, the fears for China’s exports that weighed on its markets earlier this year will largely evaporate.

The SSEC has fantastic potential to soar out of today’s silly lows, and the bullish sentiment it spawns should really light a fire under commodities stocks.  While China commodities sentiment is certainly not usually commodities’ primary driver, SSEC strength has the potential to really amplify a commodities-stock rally driven by other factors.  Its primary drivers will likely be a recovering SPX resuming its cyclical bull and the resulting weaker dollar.  But a surging SSEC will certainly add to this favorable sentiment.

As I was exploring this thesis this week, I was wondering if this first chart with non-zeroed axes was skewed.  So I built another one that indexed both the SPX and SSEC, from the former’s March 2009 lows.  This indexed perspective shows the SPX and SSEC performance since that milestone in perfectly-comparable percentage terms.  This perspective not only confirmed my thesis, but reveals today’s massive gap is even larger than the first chart indicated.

From this perfectly-comparable perspective, the latest anomalous divergence looks much larger.  And the first one during the summer of 2009 looks smaller.  Note above that after shooting ahead last summer, the SSEC fell behind by roughly the same distance before it started rallying with the SPX again in the latter third of last year.  This is classic pendulum-like mean-reversion behavior, an extreme on one side of an average being followed by a nearly-equal extreme on the other side.

By November 2009, the SSEC had nearly caught up to the SPX in performance terms since March 2009.  It really started diverging late that month, which was exactly when the US dollar bounced into a bear rally after a long bear-market downleg.  It was this healthy and expected dollar rally that initially started driving the euro lower, and it was the weakening euro that ignited the popular Europe-implosion fears centered around an extremely irrational euro-to-zero mindset.  A weaker euro has actually weighed on China since late last year, something I hadn’t realized before digesting this chart.

By this week, the divergence between the SSEC and SPX performances in their parallel cyclical bulls had ballooned to massive proportions.  The SSEC fell to 15-month lows, nearly back to where it started in March 2009.  To go from up 64% in early August 2009 to up less than 12% in early July 2010 effectively wiped out China’s entire cyclical bull!  This is insane, in the US markets cyclical bulls never give back that much regardless of sentiment.

And if all this was caused by the euro panic, which was in turn driven by the SPX correction igniting fear-driven dollar buying, then all this sentiment has already started to reverse.  As the SPX recovers and its young cyclical bull continues, the dollar will resume drifting lower again on its terrible fundamentals and the euro will recover dramatically.  A stronger euro makes Chinese goods more affordable for Europeans again and ensures Chinese exports to Europe will remain high.  And the Shanghai Comp is off to the races!

Based on the history of the SSEC’s relationship with the SPX, I totally expect the more-volatile and higher-potential SSEC to regain the performance crown in this cyclical bull.  Obviously to accomplish this, especially as the SPX is rallying simultaneously, the Chinese stock markets will have to surge dramatically like they did last summer.  And this is certainly probable, especially given how oversold they’ve recently become.

And surging Chinese stock markets will lead the world’s commodities traders to assume the Chinese economy is recovering faster, thus commodities demand should accelerate.  This major shift in sentiment should drive huge commodities and commodities-stock buying.  Given how oversold commodities stocks recently became partially due to the China-correction sentiment, their potential for gains is vast over the next 6 to 12 months.

The bottom line is the Chinese stock-market action really affects commodities sentiment globally.  Just like here in the US with the SPX, investors interpret a strong Shanghai Comp as an indication of a strengthening Chinese economy and hence expanding commodities demand.  So they rush to buy commodities and commodities stocks to capitalize on this bullish shift in fundamental expectations.

And thanks to the recent impact of Europe’s woes on China’s stock markets, the Shanghai Comp is radically oversold today.  To mean-revert back to performance norms with the US stock markets, the SSEC is going to have to rocket higher.  This bodes extremely well for commodities-stock sentiment, and will likely drive a frenzy of commodities-stock buying in the coming months.  The potential is amazing!

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