Does China's Stock Market Lead the U.S. Market?

Given the number of China-related stories in the headlines recently -- everything from tough talk on exchange rates to Google's potential closure of its China-based search engine business -- it may be a propitious time for investors to look into the relationship between the Chinese and U.S. stock markets.

Why? If there is a correlation between the two markets, then it would behoove investors to be aware of it. If China's market tends to lead the U.S. market, for instance, then the recent weakness in Chinese stocks might offer a valuable heads-up to investors in the U.S. markets.

The best way to see if there is any relationship is to pull up a chart of each market. I am using the S&P 500 as representative of the U.S. stock market and the Xinhua China 25 Index (FXI) as a proxy for China's market. Before zooming in to look at recent market action, I've chosen a longer-term five-year chart of each market.

As a simple indicator of each market's internal strength or weakness, I've placed the 100-day moving average (MA) on each chart. In technical terms, when price stays above a long-term moving average, it is bullish. If price drops below the moving average and can't reclaim a place above that trend line, then it's bearish.

As we can see, China's stock market rocketed up in a stupendous bubble, doubling and tripling on its ascent to a peak in the week of Oct.16, 2007. Though the two indices don't seem to have much in common at first glance -- one was a bubble, the other a more leisurely Bull Market -- the S&P 500 topped out just a few days before, on Oct. 9, 2007, at 1,565.

This tight correlation remained in place during the subsequent declines and rallies that culminated in the waterfall of late September 2008. Though the Chinese market fluctuated much more wildly in terms of percentage, the dips and recoveries are remarkably aligned until mid-September 2008, just before global markets imploded in the wake of Lehman Brothers' collapse.

If we look closely at the fateful time just prior to the global meltdown, the S&P 500 was still clinging to its 100-day moving average. In contrast, the Chinese market had already sagged well below its 100-day MA. With the benefit of hindsight, it is clear the weakness in China's stock market preceded the cascade just ahead. (I have drawn in black lines to mark the same time frame.)

Here is a close-up of September and October 2008, with both markets depicted on one chart. The price movement of each index is plotted in percentage points.

The Chinese market weakened more than the S&P 500 right from the start of September, but it was the steep drop in China stocks around Sept. 17, 2008, that was clearly a warning shot that all was not well.

As late as October 12th to 13th, China stocks rose sharply along with U.S. markets to "only" losing 20% of their value from Sept. 1. But the weakness presaged in September came back with a vengeance, and the Chinese market plummeted to horrendous losses exceeding 50%.

What can we conclude from this study? That though Chinese and American stock markets are highly correlated in terms of peaks and valleys, relative weakness in Chinese stocks appears to have offered a "heads-up" of trouble ahead for global markets. While the U.S. market clung to its 100-day moving average at the critical juncture, China's market had already fallen well below its 100-day moving average.

Let's now turn our attention to more recent price action in each of these markets. Here is a chart depicting the FXI and S&P 500 from Sept. 14, 2009, to March 14, 2010.

The two markets were highly correlated, rising and falling in near-unison, until early December, when the Chinese market abruptly sank. In the subsequent 10 weeks, the Chinese index continued to under-perform the S&P 500. While the S&P 500 registered a 10% rise in that time frame, the Chinese market has yet to recover positive territory. Indeed, China's stock market has recently weakened; the Shanghai Composite Index closed at 2,976.939 points on March 15, breaking the psychologically important 3,000-point level.

Correlation is not causation, which means the recent decline in Chinese stock markets may not be causing slippage in other markets. But correlations can offer clues to the future, and given the correlation revealed in the charts above, the relative weakness of Chinese stocks in the past three months should give U.S. investors pause.