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Stocks: The Chinese Correction?

S&P says charts for a fund that tracks a key Chinese index look "downright scary", and it could be due for a major pullback

From Standard & Poor's Equity ResearchWhile our technical focus tends to be on the U.S. stock market -- with some analysis of the the UK's FTSE and Germany's DAX indexes -- investor fund flows have been heavily weighted towards overseas stock markets. Investment dollars tend to migrate to better returning assets, and, in this case, much more risky assets, in our view. It seems like any stock from China is a no-lose investment. The view of some speculators appears to be "just keep throwing money at the Chinese momentum, and you're on our way to quick riches." It kind of reminds you of the days. Our warning: Don't be the last one out the door.

The iShares FTSE/Xinhua China 25 Index Fund (FXI), an exchange-traded fund (ETF), is designed to mimic the index it is named after. The FTSE/Xinhua is designed to represent the performance of the largest companies in the China equity market that are available to international investors. The index is made up of 25 of the largest and most liquid Chinese companies, and as of Jan. 3, financials were the largest sector representing almost 43% of the fund. Telecommunications is about 19% of the fund, followed by 16% for oil & gas, 11% industrials, and 9% for basic materials. The ETF first started trading in March, 2005.

We have two major concerns about the FXI, and similar overseas investments. Number one, the chart has gone asymptotic and trading volume has exploded. The second is less scientific and more of an educated guess. And that is, we doubt investors really know anything about the companies in the fund, other than that they are based in China. The saving grace may be that these are large companies with a track record and not a '90's Internet company with zero revenues and no track record.

The chart of the FXI is downright scary, in our view, and due for a major correction. The ETF bottomed out at 66 on June 13, 2006, and as of the close on January 3, 2007, has soared a remarkable 76% in less than 7 months. More incredibly, the FXI has spiked over 26% since November 28, and 13.5% since December 21. Can you say "mass speculation"?

Since the last major low in June, 2006, the slope of the advance has changed four different times, getting steeper every time. Trading volume has exploded in the first trading days of 2007, running almost three times that of average daily volume. This is very typical of a speculative blowoff, and many times, they end badly. Daily momentum is extremely overbought, and has traced out negative divergences. As of January 3, the ETF was an incredible 39% above its 200-day exponential moving average.

The cycle of market emotions has gone from optimism to euphoria very quickly. Unfortunately, it is likely to reverse to fear then panic, in our opinion. How this all plays out for the U.S. market is difficult to say, but it is not healthy and screams of an intermediate-term top, in our view.

Getting back to the comforts of the U.S. stock market, the start of the New Year was anything but dull. Despite the wild intraday volatility to open up 2007, the S&P 500 only suffered a small loss for the first trading week of the year. The index has really been boxed in of late, like a superball in a small container. Since the beginning of December, the intraday trading range of the index has been between 1405 and 1432, only about 2%. On a closing basis, the range has only been 1.4%. Up until mid-December, the S&P 500 had traced out a series of higher highs and higher lows, however, the advance at the end of December failed to make a higher high, and with today's weakness, the "500" put in a lower low.

The key area of support for the S&P 500 remains between 1380 and 1400. The 30-day exponential average, which has provided support numerous times since August, sits at 1409. There are two trendlines that come in just above the 1400 level, the 50-day average sits at 1397, and the bottom of the 21-day price envelope comes in at 1389. A 23.6% retracement of the market advance since June lies at 1379, and is also potential support. There is minor chart support in this zone as well. If the index takes out this area of support, a 5% correction of the recent high of 1427.09 would take us to 1355, which is close to a 38.2% retracement of the rally since June. A 50% retracement of the rally targets the 1325 level, a more significant zone of support, because it represented the top of the move back in May.

As we have illustrated recently, price momentum, internal data and market sentiment have been warning of a potential intermediate-term peak. However, the one thing the market has not seen, and which many times is a prerequisite for a pullback or correction, is a consistent pattern of distribution days, or heavy selling by institutions. There have only been a couple distribution days on the Nasdaq over the last month, and only one on the S&P 500. This could indicate that the market is not quite ready to rollover, and that the decline won't begin until sometime later this month.

As far as price momentum, the major indexes have all reached overbought levels on a daily and weekly basis, with some negative divergences evident. Internally, deterioration is apparent in the number of stocks making new highs and new lows. The summation of NYSE new highs and Nasdaq new highs got overbought in early December, and has since traced out lower peaks. New lows also got overbought and have started to rise, putting in negative divergences. Nasdaq up volume has been fading, while down volume has been rising over the past couple months.

In a sign of increased speculation, the ratio of Nasdaq weekly volume to NYSE weekly volume has been rising steadily since early December, and is at an overbought level that has preceded the last three pullbacks/corrections. Not to be outdone, market sentiment is rather optimistic, and in some cases bordering on euphoric. Put/call ratios have declined to overbought levels. A week ago, the Investor's Intelligence poll was showing only 19.6% bears while bullish sentiment on the Consensus poll is extremely high at 75%.

Bond yields actually fell last week, despite Friday's rise after the stronger than expected nonfarm payroll report. The 10-year Treasury note finished the week with a yield of 4.65%, and may have benefited on an intraday basis on Friday, Jan. 5, due to the weakness in stocks. We believe yields have reversed to the upside on an intermediate-term basis following the breakout above trendline support and with the piercing of the 80-day exponential moving average. The 10-year is still working on what appears to be an inverse head-and-shoulders pattern. Key chart support sits up at 4.8%. This area also represents a 50% retracement of the decline in yields since June. A break above the 4.8% level would then set the market up for a move to the 5% to 5.25% zone, in our view.

Crude oil prices tanked last week, but did manage to hold critical chart support in the $55.50 per barrel area. This area represents the low for crude oil since back in November, 2005, as well as November, 2006. The rally in December failed to follow through, running out of gas up at $64. Two pieces of resistance sit in that zone including the 200-day exponential moving average and a trendline drawn off the lows in late 2005 and early 2006. The recent sideways consolidation only retraced about 38.2% of the decline since August, and failed to push momentum above the neutral zone.

From high to low, the bear market in crude oil has erased 28% of its value. This decline knocked the 14-week relative strength index (RSI) to the lowest level since 2001, or just about when the bull market was starting. During the entire bull market, the 14-week RSI found support around the 40 level during all the corrections. The weekly RSI indicator tends to trade in a specific range during bull markets and bear markets. The latest range has been between 30 and 50, and has to be considered a bear range. It appears there is a good chance that crude will break $55 support. If that happens, it will open the door up for a decline to the $45 zone. There is chart, trendline, and Fibonacci support in that area. In addition, another 28% decline from the recent peak at $64 would target the mid-$40s zone.

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