China Deep Dive

From the desk of Steve Strazza @sstrazza and Louis Sykes @haumicharts

We continue to experience a bullish expansion in participation from stock markets around the world.

Just a few days ago we discussed buying Israeli stocks and explained how their strength at the index level was being driven by their heavy exposure to Technology.

Mega-Cap Growth and Tech stocks (we're including Communications and Discretionary here -- "Tech but not Tech" names such as Alibaba, Tencent, Meituan, JD.Com, etc.) are also a dominant market force in China.

We wrote about this exact topic in November, and how strength from these names would likely continue to propel these Large-Cap Chinese Indexes and ETFs higher. The Chinese Tech ETF $CQQQ and iShares Large-Cap China ETF $FXI tacked on an additional 24% and 12%, respectively in the time since.

Now, we're seeing FXI back to its key former highs and attempting to break out of a decade-plus base. JC followed up on this theme in a post where he points out that the relative rotation in favor of Chinese Tech over the US is not only still taking place... but is beginning to accelerate and become even more pronounced.

After a little more digging, we think this is a much bigger story as this relative strength at the sector level expands across the board.

That's why we're taking a deep dive into the world's second-largest economy. Not only do these strong internals support higher prices in China on an absolute basis -- they also suggest a structural reversal is underway relative to the US.

Here's what we'll be covering:

1. The Chinese Large-Cap Index attempting to break out in USD terms
2. The strong internals supporting a breakout at the index level as many of China's sectors are also making new highs
3. These same sectors are either breaking out or already trending higher on a relative basis vs their US peers
4. China is at a logical level from an index standpoint to carve out a bottom relative to the US as the ratios consolidate at former lows
5. And, of course... trade ideas not just at the index level, but also some of its strongest components we want to buy to take advantage of this emerging trend

Let's get started...

Here's a high-level view of the Chinese market, represented by the iShares China Large-Cap ETF $FXI.

Just look at buyers pushing price back to this critical 53 level for the fourth time in the last decade...

Whenever we see buyers attracted to an important resistance zone like this, it's only a matter of time before they absorb all of the sellers. With each successive test of a level of overhead supply, the higher the likelihood it breaks. These retests have also become more frequent since 2015 and price has achieved a pair of marginally higher highs and higher lows.

Considering this is the fourth time we're back to this level, an upside resolution is the bet we're making.

Here's a more short-term look at FXI.

We saw more evidence of this last week as FXI gapped above last year’s high as it heads right back toward the scene of the crime in the low 50’s.

We want to be buyers of FXI and Chinese stocks in general if we finally get a decisive breakout above this critical resistance zone.

We're going with the 2018 high of 54 to be safe. If we’re above that, we’re long and targeting the all-time highs at 73 over the next 1-year+.

Here's another iShares China ETF $MCHI, which is far more representative of the overall Chinese market with over 600 names vs just 50 in FXI. Here is the Fact Sheet if you’re interested.

Following back-to-back weeks of strong gap moves, MCHI is now trading right at our most recent objective.

We're long above 93.50 with a target of 120 over the next 1-year+.

Despite the broader exposure as MCHI comprises 85% of the entire Chinese equity universe, its sector weight is still dominated by a near 40% allocation to Discretionary (tech but not tech), followed by Communications (tech but not tech), Financials (definitely NOT tech), and Healthcare (some tech)… much like FXI.

Here is the ratio chart of the two, showing MCHI cruising higher in orderly fashion since its inception almost 10-years ago.

We could argue that this relentless relative strength is yet another feather in the hat for Chinese equity bulls as this speaks evermore to the healthy internals in China. I mean, considering the different construction of these indexes, participation must be broad-based for MCHI to outperform the way it has been.

Despite all this, relative trends are subject to change just like anything else.

Additionally, FXI does have more price memory, and thus a larger and more formidable base. This gives investors a clearly-defined and well-tested level of interest to trade against, which should act as strong future support.

Long story short, we think you can exercise a bullish thesis on China using either of these ETFs. Depending on preferences, one might make sense for some, while the other could be a better-suited investment for others.

Moving on...

Not only is the outlook bullish at the index level but we're going to drill into the country's sectors now to illustrate the strong breadth currently supporting the new highs in the Large-Cap ETFs discussed above.

First up is Industrials $CHII.

Bullish momentum and fresh 5-year highs. Check.

Definitely bullish for China, but probably a huge positive for global growth as well considering they're the largest manufacturing economy in the world.

Here's Materials $CHIM breaking out of a similar base.

Working on a base breakout to its highest level in about 10-years. Check.

Now Healthcare $CHIH.

Since the ETF's inception in 2018, it has never fallen into oversold conditions. This resiliency is evidence of the strong hand of buyers, who have been firmly in control of this trend since the beginning.

Check.

And here's the 2nd largest component, weighing in at 20%.

After an explosive move recently, the Communications sector is headed right back to those all-time highs from almost exactly 3-years ago. Check.

Last but not least is Discretionary $CHIQ, the secular leader and main driver of the major indexes.

This is an absolute nosebleed of an uptrend. If the US is in a bubble... what the hell do we call this?

Then again, it makes sense when you consider many of the largest stocks in China are secular leaders from the Internet Retail industry. We're talking Meituan, Alibaba, JD, and Pinduoduo, which make up a combined 25% and 32% of MCHI and CHIQ, respectively.

While these ETFs unfortunately aren’t liquid enough to trade, they are great from an information standpoint.

And the information they're giving us presently is when you look under the hood of the index there's some very healthy participation supporting MCHI and the Chinese stock market.

But the bull case for China doesn’t just end with strong internals. These sectors are also exhibiting bullish relative strength vs their US peers.

Here's all the Chinese Sector ETFs plotted against their US Sector SPDR equivalents.

Every sector except for Financials and Energy are outperforming their US counterparts in dollar-denominated terms.

To be fair, Financials make up a notable 13% of the MSCI China index - and they are not looking too good at all on a relative basis right now.

They are a mess on an absolute basis as well, with price still trapped below their pre-COVID and summer pivot highs. To add some perspective, despite being a secular laggard and one of the weakest sectors in the market, US Financials were still able to make a move back to their pre-COVID and even all-time highs recently.

While we do want to keep an eye on this, it's Discretionary, Communications, and Healthcare that really matter as they make up a combined 64% of the MSCI China Index and are all in the midst of some stellar uptrends on both absolute and relative terms.

Let's take a step back and think about all the developments we just discussed.

1. All but two of China’s sector ETFs have exhibited impressive relative strength vs US sector ETFs.
2. These same sectors are in structural uptrends, making new highs, and/or breaking out of major bases on absolute terms.
3. Finally, we have the potentially massive base breakout materializing in FXI itself (supported by strong sector internals noted above).

When we consider these items in the context of our weight of the evidence approach, it's hard not to imagine the relative trend in China vs the US playing out in any other way than this...

We believe confirmation of the potential failed breakdown and potential bullish momentum divergence are likely to confirm and spark this long-term bear-bull trend reversal any day now.

If this ratio reclaims that key 0.015 level, the risk is to the upside and we want to favor Chinese stocks over the US.

We believe this is the higher probability outcome, as the relative strength heavily favoring China beneath the surface is likely to propel this ratio higher from here.

As we discussed in this week's RPP Report, we're seeing a similar development at the Global Index level in local currency as well.

This ratio shows China's Shanghai Composite dating back to 1994... also at a logical level for a long-term trend reversal to take place.

Just like FXI, price appears to be gaining its footing and carving out a bottom at the exact same level where past structural lows took place.

These relative ratios are at key inflection points and showing evidence of trend reversals while the underlying internals strongly suggest a resurgence in outperformance from China.

The seeds have been planted. Now we can only wait for more data to come in and either confirm or disprove our thesis.

Now let's dive into some of the individual components that are not only showing leadership and driving the strength in these ETFs but also offering risk profiles skewed heavily in our favor.