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Traders have been watching the 2500 level on the Shanghai Composite Index closely for the last week.

And today they got the price action they feared. The index dropped another 4.3% today to close at 2427.

That’s below both the psychologically important 2500 level. (Yes, the market does seem to react to round numbers. Nobody ever said investing was a science or even especially rational.) And below the 2481 level that signaled support on the charts to technicians.

So we’re at one of those moments when selling begets more selling as traders who have watched the charts decide to sell because stocks have dropped below support levels on the charts.

The ostensible reason for today’s sell off is a revision to the April report by The Conference Board Leading Economic Index showing that its leading economic indicator, which had shown a 1.7% increase in April when it was reported on June 15, should actually have indicated only a 0.3% increase. The problem was a calculation error involving the total floor space in new construction in the month.

So, yes, a leading indicator of growth based on April numbers is lower than previously reported.

Only a very, very nervous market reacts with a 4.3% drop to news like that.

The market also reacted badly to news yesterday that the IPO (initial public offering) of the Agricultural Bank of China had priced for less than expected in Shanghai. I’ve been following this offering as an indicator of the direction of China’s stocks for months. The fear is that China’s banks won’t be able to raise all the capital they need—some $40 to $50 billion plus the $20 to $30 billion of the Agricultural Bank’s IPO. And weak pricing for the Shanghai section of the Shanghai/Hong Kong deal feeds right into that fear. (For more on this indicator see my post )

There’s probably more damage ahead too. Selling accelerated once the index broke below 2500.  

The next level of support for the index is near 2000. And I think this market is nervous enough to push lower toward that level. The Shanghai Composite is now down 26% for 2010 and 30.2% from its August 2009 high. A drop to 2000 would be a decline of another 17.5%.

You can, though, also see the potential recovery in this index building strength. A 30% decline is starting to seem very tempting to investors who believe in China’s long term potential and who have been waiting for any entry point. (I’d put myself in that number.) Nobody wants to jump in quite yet and take a chance on another 17.5% drop but at some point the urge to buy a bargain will exceed the sense of a risk.

Not yet perhaps. But soon.

Full disclosure: I don’t own shares of any company mentioned in this post.