Major Moves

Although bullish confirmation is still valid, the major indexes stalled today as investors worried about trade and another possible government shutdown. I remain confident that one of the key factors that will send the market higher (or lower) is whether trade conditions between the U.S. and China improve (or deteriorate) compared with where they are now.

As I have mentioned in previous Chart Advisor issues, the Chinese markets are unfortunately closed for the week, which means we're not getting any official data and it's unlikely that we will receive any updates on trade negotiations. However, we are able to see whether investor sentiment in the U.S. relative to China is changing.

Most of the exchange-traded funds (ETFs) in the market that track Chinese stocks have Chinese or Hong Kongese-listed stocks in their portfolio. If the ETF trades on U.S. exchanges, investors can push the price of the ETF's shares higher or lower even if the prices of the underlying shares held by the fund are technically unchanged. The most recent market price of an ETF's holdings is called its net asset value (NAV), which can deviate from the ETF's per-share price.

If investors are feeling very confident about a market, the share price of a related ETF can rise above the fund's NAV per share. For example, the iShares China Large-Cap ETF (FXI) has a net asset value based on last Friday's market price of $42.69. However, Tuesday's close price of the ETF's shares was $43.41, which indicated that investors were expecting the underlying stocks in the fund to rise in value once the holiday in China is over. Today, however, that excess valuation evaporated as emerging market stocks dropped in value at a far faster pace than U.S. equities on Wednesday.

As you can see in the following chart, FXI has had a fairly wide trading range over the past two days as investors try to price in the potential for changes in the U.S./China trade relationship. You will also notice that the ETF's chart makes it look like Chinese stocks are still struggling against resistance, which is not quite true if we look at Chinese stock indexes directly that are priced in yuan. However, in either case, the rally is still relatively new, and a breakout is uncertain until we get more positive news about trade negotiations.

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Chart showing the share price performance of the iShares China Large-Cap ETF (FXI)

Risk Indicators – The USD

Part of the reason that ETFs holding shares of Chinese companies (and other emerging markets) look a little worse than the actual indexes for those stocks is due to a stronger dollar. If the dollar rises in value relative to the yuan or other emerging market currencies, it deflates the potential gains from those foreign investments and can increase the potential losses.

For example, imagine that a group of foreign stocks held by an ETF has paid a dividend of 100 yuan but the value of the dollar has risen by 5%. When the dividend is translated from yuan into dollars, it will have lost 5% in that process. From March through October 2018, the dollar gained over 10% against the yuan, which reduced demand for Chinese investments. In the short term, a falling dollar would be supportive for international trade because it tends to be anti-inflationary in emerging markets and it makes U.S. goods more competitive. That should improve the U.S. trade deficit.

A falling dollar is also a sign of confidence that investors are not seeking shelter from volatility. However, over the past five days, the dollar has been rising. As you can see in the following chart, the emerging head and shoulders pattern in the dollar – which I mentioned in one of last week's Chart Advisor issues – has started to fade and is looking less likely to complete in the short term. In my view, it is unlikely that we'll see U.S. stocks back to their prior highs without an accompanying decline in the dollar.

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Chart showing the performance of U.S. Dollar Index Futures

Bottom Line: Looking for Guidance

There are still a lot of earnings to be reported this week, including a few life insurance companies like Prudential Financial, Inc. (PRU) and MetLife, Inc. (MET), which report late Wednesday afternoon. These reports should help us understand the outlook for corporate performance a little better. Life insurance companies are very sensitive to changes in interest rates and expected return from the market. If forward guidance provided by management at the insurance companies is positive, it's likely to give the markets another boost to the upside.

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