Investing

The Cyclical Nature of China and the U.S.

By Adam O'Dell  |  October 10, 2018

It’s been a pretty good year for U.S. stocks.

All four of the major U.S. indices are up – between 4.8% (Russell 2000) and 13% (Nasdaq 100).

Foreign stocks, on the other hand… not so hot.

Foreign developed-market stocks (EFA) are down 7%…

European shares (FEZ) are down 9%…

And Chinese stocks (FXI), along with the broader emerging-markets group (EEM), are down nearly 15% – oh, and they’re officially in bear-market territory, having fallen more than 20% from their highs.

It’s interesting to me that this story – of what we call divergence between U.S. and foreign stocks – has begun to capture the attention of the media recently.

In reality, U.S. stocks have outperformed foreign stocks for nearly the entire bull market that began in March 2009.

Take a look at this chart, taken from J.P. Morgan’s latest Quarterly Guide to the Markets, which shows the total return difference between the two…

Total Return Differences Between the U.S. and Foreign Markets

That’s right, the S&P 500 has nearly tripled the return of foreign developed-market stocks since the 2009 bottom – handing U.S.-concentrated investors 331% versus 115%.

As you can see in this chart, it’s not uncommon for one to outperform the other during a bull market.

For instance, in the 1997 to 2000 rally, U.S. stocks doubled the return of foreign stocks.

And in the 2003 to 2007 bull market, we saw just the opposite as foreign stocks doubled the return of U.S. stocks.

But the current divergence is gathering attention because U.S. stocks have now tripled the return of foreign stocks. And also because the increasingly antagonistic trade war talk has many wondering who will win in a faceoff between the world’s top two economies – the U.S. or China?!

Of course, a definitive answer to that question is beyond my expertise. I honestly don’t know who will blink first, let alone what intended (and unintended) consequences will follow.

But I can help you quantify the recent divergence between U.S. and Chinese stocks… and perhaps even offer a solution to figuring out where you’ll be able to make the safest gains.

For that, let’s consider a chart I’ve put together, which shows the difference between U.S. and Chinese stock returns on a rolling three-month basis:

The Difference Between U.S. and Chinese Stock Returns

Even though U.S. stocks have outperformed Chinese stocks by more than four-to-one since the March 2009 bottom, there have been many times throughout this bull market when Chinese shares have been a better bet.

The simplest conclusion you can draw from the chart above is that the outperformance relationship between the U.S. and China is cyclical.

The U.S. will outperform for several months… then Chinese stocks will outperform for several months… then U.S. stocks will regain the lead… and so on and so forth.

The 15% to 20% range of outperformance has generally acted as an upper limit. Meaning, once U.S. stocks have reached a point where they’ve returned 15% to 20% more than Chinese stocks, over a three-month period… they tend to cool off for a while, allowing for a period of Chinese outperformance.

And likewise, once Chinese stocks have beaten U.S. stocks by 15% to 20%, the cycle reverses and U.S. stocks catch back up.

This is important now since U.S. stocks hit that 20% outperformance threshold in September. And we’re already seeing signs of weakness in U.S. stocks, while Chinese stocks aren’t falling as quickly as they were.

One way to take advantage of this rather predictable cyclicality is to put on a pairs trade.

Put On a Pairs Trade

A pairs trade involves buying one stock market ETF, and selling short an equal-dollar amount of a different stock market ETF.

In this case, the natural pairs trade to consider is:

  • Buy China (FXI), and
  • Sell short the U.S. (SPY).

A paired position like this can actually profit from three different scenarios.

First, if both markets move higher… you can profit as long as Chinese stocks gain more than U.S. stocks.

Second, if both markets move lower… you can profit as long as Chinese stocks lose less than U.S. stocks.

Thirdly, if Chinese stocks move higher while U.S. stocks move lower… you can profit as the two markets move back in line (aka converge).

No one really knows for sure which way the market is heading, let alone what will come of the trade war talk between the U.S. and China.

This pairs trade is one way to position yourself for uncertain times, taking advantage of the cyclical relationship between U.S. and Chinese stocks – regardless of overall market direction.

Adam O'Dell

As Chief Investment Strategist for Dent Research, Adam O’Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with minimum risk. He achieves this with his perfect blend of technical and fundamental analysis.MORE FROM AUTHOR