Over the years, I have found that when talking to experienced traders you can often learn more from trades they don’t do than ones they do. When somebody has a particular style and an opportunity that seems to suit that style is rejected, the inevitable question “Why not this time?” can result in some interesting answers. Here’s why traders should be leaving one obvious trade alone this week.
Over the last couple of weeks I have been looking closely at emerging market stocks. The collapse in the Chinese market, the continued strength of the U.S. dollar as a rate hike is anticipated, and now China’s devaluation have caused a huge drop in the sector in the last few months. The Vanguard FTSE Emerging Markets ETF (VWO), for example has lost around 20 percent since the end of April, and is trading just a dollar or so from the 5 year low of $35.83.
Regular readers (God bless you!) will probably be aware by now that this is the kind of setup I love. To some extent the danger in catching a falling knife can be mitigated by placing a stop loss order just below that nearby known support level and the potential upside from a rapid bounce is usually enough to make the risk worthwhile. In this case, though, VWO looks like one to avoid for now for two reasons, one technical and the other fundamental.
From a technical perspective, while we are close to the 5 year low, we are right at a far more important support point. $36.65 represents the low of the range that VWO has been stuck in for the last three years or so, a support level that has been tested four times so far. If that level breaks then $35.83 is likely to be taken out quickly as the longs run for cover. In order to take that risk and buy now, therefore, there has to be a compelling fundamental case that a bounce is coming and, if anything, the opposite is true right now.
Let’s look at one factor at a time. The Chinese stock market slide shouldn’t concern anybody in many ways. As many commentators have pointed out with 20/20 hindsight, it was a bubble ready to burst, and the nature of the Chinese market means that the link between stock prices and economic conditions is even more tenuous than elsewhere. It is virtually non-existent. The problem is that as more and more people jumped on board, the rising market did create paper wealth for a lot of people and should have stimulated economic activity as a result; the so called “wealth effect.”
As for the devaluation of the Chinese currency, one would normally expect the immediate market reaction to something like that to be overdone, but in this case it almost certainly isn’t, for one basic reason. We have no idea to what extent the People’s Bank of China (PBOC) intends to devalue, or on what timetable. They denied a 10 percent target for devaluation this morning, but the surprise would have been if they said anything else. Given complaints about an artificially low yuan in the U.S. and elsewhere, the Chinese central bank acting as cheerleader for further devaluation would amount to a provocation.
The fact is, though, that the yuan has already been devalued by around 4.5 percent. That influences the dollar value of around 27 percent of VWO’s holdings of course, but it also does far more. What China is essentially doing is attempting to export its own deflationary pressures. Large developed economies will probably be able to absorb that export, but for other emerging markets it will be a different story. India, Brazil and South Africa among others will probably be forced to devalue as well in order to remain competitive. Just that knock on currency effect should cause another 5-10 percent drop from current levels, taking us through the $35.83 support.
At some point, VWO and other emerging market ETFs will be a steal. Despite the attractiveness in many ways of the current pricing based on proximity to significant levels, however, the fundamentals point to them tracking even lower. In that situation, discretion is likely to prove to be the best option.