China’s Shanghai Index appears undervalued. But that doesn’t mean it won’t be even more undervalued in a few months.
Of course, “undervalued” is a relative term. Anytime I hear someone make a claim about value, I always follow with the question, “Compared to what?”
In today’s chart, I’ve made a comparison between the Dow Jones Industrial Average and the Shanghai Index. The yellow line below is a ratio of the two (Shanghai ÷ Dow Jones).
This ratio has been steadily declining since 2009. This means the Dow Jones has gotten relatively stronger, and the Shanghai relatively weaker, during this time. And that’s one way to provide analytical backing to the claim that the Shanghai is currently undervalued.
Besides showing the yellow ratio line, I’ve also included in the chart above the actual Shanghai Index (at the top) and the RSI indicator (at the bottom).
The RSI shows overbought levels in red (indicating the market is overvalued) and oversold levels (indicating the market is undervalued) in blue. This is a very useful indicator, but I always keep the current trend in mind when interpreting the data. Here’s why…
In downtrends, the red overbought levels are great places to get short. You’ll see two instances of the Shanghai reaching this overbought level and both times accurately picked long-term tops. Short-sellers did quite well shorting these signals.
On the other hand, the oversold levels shown in blue can be dangerous in downtrends. Investors expect the market to bounce higher when the RSI reads oversold – when it appears the market is undervalued – but this doesn’t always happen during long-term downtrends like the one the Shanghai has been in since 2009.
You’ll see in the chart that each time the oversold level was hit, the market continued lower instead of shooting higher as hopeful investors had expected.
Looking forward, RSI on the Shanghai is very close to reaching the oversold level again. Don’t be fooled – this is not a buy signal. As Harry points out above, China’s economy is B.S. and its market knows it.
If you haven’t done so already read the Survive & Prosper issue on “What Happens When High Savings Meet Over Investment.“