Three Charts — Could China be Close to a Bottom?

Key Takeaways

• Investors in China have had a challenging couple of years. Ongoing economic woes have pushed stocks into a bear market and back to their pandemic-era lows.
• Oversold conditions and bearish sentiment have both reached extremes. And while both conditions can persist for meaningful periods, technical evidence is building for a potential capitulation point in Chinese equity markets.
• Historically washed-out selling pressure, coupled with bullish price action, volume, and momentum off the recent lows provide constructive signs that a bottom could be near, but no guarantee.
• Increased policy support from Beijing and a recent surge in mainland exchange-traded fund (ETF) inflows provide additional catalysts for capitulation.
• It is important to note that identifying market bottoms is a difficult challenge riddled with risks, especially in China given the degree of government policy influence over price action.

Market Bottoms

The allure of identifying a bottom in the market has captured investors' interest for as long as stocks have traded. It is not just traders or technical analysts chasing the proverbial falling knife, as pundits from anywhere from academia to Warren Buffett have thrown their names in the hat by trying to time a market low. It is no easy task, even for the Oracle of Omaha, who is famously contrarian, at least based on one of his better-known quotes, “Be fearful when others are greedy, and be greedy when others are fearful.” Buffett took this approach and prematurely missed the bottom in March 2009, and by his admission in the aftermath confessed, “We have not been good at timing.” Luckily, he has been very good at just about everything else when it comes to investing.

While many investors have rigid rules related to identifying market bottoms such as climactic selling pressure, surging implied volatility, extremely oversold momentum, bearish sentiment, and the shape of the bottom and occurrence of retests, investors should keep an open mind as not all market bottoms are equal. For example, the October 2022 lows were not accompanied by a new high in the CBOE Volatility Index (VIX) or were ever retested (the latter also applies to the bottoms in 2020 and 2018).

Undoubtedly, there is always someone asserting what the market must do before a low is set, but it is important to remember the market will do what it wants to do when making a bottom, not necessarily what you think it should do. Furthermore, nailing the market low is nearly an impossible task and usually involves a little luck. LPL Research believes that utilizing a weight of the evidence approach can get you close enough, or at least help identify an attractive risk vs. reward entry point.

Are Chinese Stocks Close to a Bottom?

To say it has been a rough couple of years for Chinese investors is an understatement. The Shanghai Stock Exchange Composite Index (SSE Index), comprised of over 2,000 Chinese companies and the world’s third-largest stock market based on market cap, remains in a bear market, and recently fell to its pandemic-era lows. An underwhelming economic reopening following strict COVID-19 lockdowns, an ongoing real estate crisis, shadow banking uncertainty, deflation, and surging youth unemployment are just a few of the concerns plaguing risk appetite in the country. This backdrop has created a negative feedback loop along with several headlines calling China “uninvestable,” a term that usually implies sentiment can’t get any worse and a bottom may be close.

From a technical perspective, evidence is also building for a potential capitulation, whether that means a shorter-term relief rally is coming or a major bottom is near can only be determined with the benefit of hindsight. Nonetheless, they both start the same way — with stocks no longer making new lows — and present at least a trading opportunity based on risk tolerance and investment timeframes.

The following charts highlight some of the key technical evidence pointing toward a potential capitulation in China.

Start with the basics, the SSE Index has bounced off a major support level. As illustrated below, the SSE Index recently inflected higher off the March 2020 lows. A doji candlestick (defined by essentially an equal open and closing price), followed by a large bullish engulfing candlestick kicked off the recovery that was further accompanied by a bullish Relative Strength Index (RSI) divergence and above-average volume. A close above resistance at 2,910 would reverse the current downtrend and raise the odds of this recovery being sustainable (and not just a relief rally).

SSE Index Finds Support Off the Pandemic Lows

Source: LPL Research, Bloomberg 02/08/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. 

Selling pressure recently hit washed-out levels. The chart below highlights the SSE Index along with the percentage of constituents oversold based on an RSI reading of 30 or less and the percentage of stocks at new 52-week lows. Just last week, both metrics exceeded the 70% threshold, marking one of their highest levels in 20 years. Historically, readings of this magnitude have overlapped with major market bottoms. Furthermore, on the bottom panel, we included the percentage of stocks registering new four-week highs, which are finally starting to emerge. While not a perfect signal, a ramp in new four-week highs following extremely oversold momentum has often overlapped with major turning points on the SSE Index.

Oversold Conditions Have Reached Extremes

Source: LPL Research, Bloomberg 02/08/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. 

Follow the money — inflows into Mainland ETFs have surged. As we noted in our “How Markets Could Surprise Us in 2024?” blog last week, “Markets stop panicking when policymakers start to panic.” Every day there seems to be a new headline about additional stimulus measures from Beijing. Chinese President Xi Jinping met with regulators this week to discuss equity market conditions, sparking speculation more policy actions may be forthcoming. The other big news this week was that Central Huijin Investment, a state-owned enterprise unit, vowed to increase ETF holdings to help stabilize markets. Speculation is that they have already been very active in the market this year, demonstrated by surging inflows into mainland China ETFs. The chart below highlights the inflows across five of the largest equity mainland ETFs that have historically been targeted by Central Huijin Investment and others on the so-called “National Team,” a consortium of state-related entities tasked with supporting equity market stability.

Inflows into China ETFs Have Surged

Source: LPL Research, Bloomberg 02/08/24
Disclosures: All indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. 

Summary

Technical evidence is beginning to build for a potential capitulation point in Chinese equity markets. Oversold conditions and sentiment have both reached extremes as the SSE Index holds above a key support level. Policymakers have been active with stimulus measures, and with President Xi Jinping becoming more involved, there is likely more meaningful stimulus on the way. It is important to note that while technical analysis can often lead fundamentals, identifying market bottoms is a difficult challenge riddled with risks, especially in China given the degree of government policy influence over price action. Moreover, economic conditions have yet to materially improve, although if/when they do, stocks will likely be well ahead of it. Based on this backdrop, LPL Research continues to favor U.S. markets over emerging markets and views the potential for a capitulation in China as more of a trading opportunity rather than a longer-term investment.