How US equity investors should trade the Evergrande panic

In the US, the S&P 500 had been largely immune to Evergrande news until today. The index decisively violated its 50 dma. Investors are becoming spooked not only over the possibility of an Evergrande contagion but a looming crisis in Washington over the debt ceiling.

Is this a buying opportunity, or a crack in the dam that foretells disaster?

A domestic crisis

Take a deep breath. An Evergrande collapse is unlikely to spark an emerging market crisis and contagion. That’s because most of the company’s debts are RMB denominated and little is in USD and other foreign currencies. John Authers rhetorically asked the same question:

So here is the key question: What kind of a moment will the Evergrande Moment be? Will it be a Minsky Moment, akin to the Lehman collapse? Or will it be more akin to the LTCM Moment? Or might it just be altogether less momentous? To measure this we need to resuscitate another concept of which many of us thought we had heard the last more than two decades ago: Asian contagion. How much effect will Evergrande’s troubles have on the rest of us?

Global markets have been relatively unscathed by the crisis. There will be little global contagion effect because it will all be contained in China.

So why is there still relative calm? It boils down to a close reading of the Chinese authorities’ intentions. They have no interest in staging their own Lehman. There has been alarm about the possibility of a Minsky moment for years in Chinese circles, frequently voiced out loud. Officials know what could happen and are determined to prevent it if they can. Efforts to rein in credit have been going on for years. And Evergrande is in trouble largely because the government itself decided to clamp down on property developers through the “three red lines” policy last year.

Authers concluded:

To be clear, an LTCM outcome isn’t great. It leaves the risk of more moral hazard. And while the PBOC can probably avert a full-blown credit crisis, it can’t stop the weakness of the property sector turning into disappointing economic growth for China. Many small savers and hopeful property buyers will inevitably be hurt by whatever deal can be thrashed out — and the  precise shape of that deal will matter a lot. But for the moment, world markets are nervous that this could be another LTCM, while comfortable that it won’t be a Lehman. On balance, both of these points look reasonable. Now let’s see what happens.

A number of bearish investors have pointed to plummeting iron ore prices as signs of slowing growth in China, which could have global repercussions. But George Pearkes at Bespoke pointed out that steel and other industrial metal prices are still holding up well.
 

 

Relax. Any contagion effect will be minimal.
 

 

A panic bottom?

In the US, the stock market is starting to flash signs of a panic bottom. The Zweig Breadth Thrust Indicator has plunged into oversold territory, which is often a signal of a short-term bottom.
 

 

My S&P 500 bottom models are starting to flash buy signals. The 5-day RSI is deeply oversold. The VIX Index has surged above its upper Bollinger Band, which is another oversold signal. The term structure of the VIX inverted intraday, indicating fear.
 

 

To be sure, this week (the week after September OpEx) is historically the weakest week of the year, as documented by Rob Hanna at Quantifiable Edges. However, Hanna pointed out that the average weekly “weakest week” drawdown is -2.3%. As the S&P 500 is -1.7% today, the index is nearing its average downside target.
 

 

While oversold markets can become more oversold, a bottom is near. Nevertheless, this market isn’t without risk. Mark Hulbert studied the stock market’s return in the two weeks prior to debt-ceiling showdowns and returns have been disappointing. As well, the FOMC meeting this week could be a source of volatility.
 

 

My inner trader plans to take an initial position on the long side in the S&P 500 at the open tomorrow morning. This is a volatile market and traders should size their positions accordingly. Be prepared for a short-term bounce, followed by a retest of the lows later this week or possibly next week.