Commodity price drop and China's role

China leads commodity price boom -- and bust

This is staggering and defies belief. Obviously China is the world’s hottest economy, with incredible sustained growth. As it expands and thrives, shouldn’t its stock markets rise to reflect the vast new profit streams and wealth being created? With its economy growing between 8% to 9% annually since then, its stock markets falling 38% are definitely not reflecting these super-bullish underlying fundamentals.

For a simple illustration, let’s assume China’ GDP averaged 8.5% annual growth over the past 3 years (the actual is higher). So between early 2009 and early 2012, China’s economy grew by nearly 28%. No matter how overbought the SSEC may have been in mid-2009, there is no fundamental justification for it trading at similar levels today to when the Chinese economy was much smaller. Economic growth drives revenues and profits, and profits drive stock prices.

So odds are the Shanghai Comp should be much closer to the SPX’s indexed cyclical-bull performance than it has been. I don’t know where the exact number ought to be, of course, but let’s conservatively assume that half the divergence between the SSEC and SPX needs to vanish fundamentally. In order for this to happen, the Chinese stock markets would have to rocket about 50% higher! This is an enormous move.

And when the Chinese stock markets finally start reflecting the incredible economic success story in China, investors and speculators around the world will become a lot more comfortable with its growth prospects. A rallying SSEC emerging from its cyclical bear will quickly turn China sentiment from bearish to bullish. And as traders grow optimistic on this country, capital will almost certainly migrate back into commodities again.

Unfortunately with today’s SPX upleg getting long in the tooth, the fundamental normalization of Chinese stock prices isn’t going to all happen before this SPX upleg gives up its ghost. So even though the oversold commodities are due for a sharp rebound rally right now, they aren’t going to enjoy the full benefit of sentiment on China changing before spring seasonals peak. So most of these bullish China tailwinds for commodities will probably have to wait for future uplegs.

Nevertheless, the years of China growth fears hammering commodities are probably effectively over. Cyclical bear markets, and stocks trading near panic levels, simply make zero fundamental sense in a thriving rapidly-growing economy. As traders around the world start to realize this and bid up Chinese stocks, the bearish sentiment surrounding China’s economic outlook will inevitably turn bullish.

At Zeal we’ll be ready for this major shift. While our commodities-stock positions have been crushed like everyone else’s in this upleg’s anomalous divergence, we eagerly await future buying opportunities. By the time the selloff matures that will come after today’s SPX upleg tops, the Chinese stock recovery ought to be in full swing. This will first limit and then eliminate the festering China fears that have weighed on commodities. And after so much pessimism and fear, commodities are overdue for a massive upleg.

The bottom line is irrational China fears have indeed been a drag on commodities in recent months. Traders’ worries about China’s stellar GDP growth rates decelerating have been exacerbated by China’s cyclical bear market in stocks. But with the flagship Chinese stock index finally bottoming and rallying, the stiff commodities headwind should soon abate. China sentiment will morph from bearish to bullish.

Chinese stocks, which heavily color global traders’ perceptions about the health of China’s economy, are overdue for a major bull market to reflect that country’s strong economic growth. And as rising stocks ratchet up China enthusiasm, capital will naturally flow back into commodities as a consequence. A positive China dynamic for a change should considerably amplify the next big commodities upleg.

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