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Weakness in Chinese stocks signals trouble in US stocks?

Some believe the Chinese and U.S. stock markets are becoming more correlated. This has gained traction following the Covid-19 pandemic crisis as many believe the reopening of the Chinese economy would ignite a global economic recovery and, in turn, boost the U.S. stock market.


However, studies show the daily returns on the U.S. and China's stock markets are not correlated. Instead, the correlation between the S&P 500 Index (SPX) and Shanghai Composite Index (SSEC) remains loose as there is a lack of a direct relationship between the two markets.


Despite being the two largest economic countries in the world, based on GDP figures, and having large stock market capitalizations, China's stock market remains relatively young and continues to play a less significant role in the global economy than they do in the United States.


The Chinese stock markets, with the Shanghai Stock Exchange and the Shenzhen Stock Exchange, have only been trading for decades, while the New York Stock Exchange (NYSE) and the Dow Jones Industrial Average (INDU) date back centuries.


The U.S. equity market remains the largest, most influential, liquid, deep, and efficient globally. As of the second quarter of 2023, U.S. stocks are $46 trillion or 42.5% of the 108.6 trillion global equity market cap. China is slightly over $10.5 trillion in equity market cap.


The NYSE has a market cap of over $25 trillion, and NASDAQ is around $21 trillion. The Shanghai Stock Exchange has a market cap of $7 trillion, and Shenzhen Stock Exchange has a market cap of over $4.5 trillion.


Besides trading in different time zones, stock markets in China are not as connected to their local economy, and financing differs. U.S. stocks are directly tied to the U.S. economy and require funding and financing from banks, capital markets, retail, and institutional investments. Chinese companies are less likely to require bank or retail/corporate financings, relying instead on government and state agencies.


Professional and institutional-type investors play a critical role in U.S. stock markets. On the other hand, Chinese stock markets are dominated by retail-type investors. Stocks in China are primarily owned by Chinese-based investors, as only 5% of shares of Chinese stocks are held by international investors. U.S. stock markets have a mix of domestic and international investors.


Technically speaking, the daily charts show a short-term correlation between SPX and SSEC from the October 2022 market bottom, as both indices traded in the same direction. In March 2023, the correlation between the two markets weakened, as SPX trended higher, while SSEC traded sideways to down.


SPX also traded to overbought levels in mid-to-late July 2023 and soon recorded a negative outside (8/2/23) and a bearish island reversal (8/2/23). SSEC, on the other hand, generated a positive outside day (7/28/23) and gap-up (7/31/23).


Will US/China trade disputes begin to influence co-movements between U.S. and Chinese stock markets?


Does the recent divergence between SPX and SSEC signal Chinese stocks taking over the leadership role from U.S. stocks, at least from a near-to-medium-term perspective?


Is this a short-term trading phenomenon as money temporarily flows into markets (i.e., SSEC) that have not participated in the stock market rally this year?


Source: Chart courtesy of StockCharts.com

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