My last week’s article about China being overly heated was just a coincidence with today’s 8% drop in China market. Anybody could have bet that Shanghai composite index, the most widely watched indicator, has grown at an unsustainable pace of 60% this year. This is in addition to the huge run-up in excess of 130% in year 2006. Clearly, Chinese government is concerned with this pace and it wants to slow down this.

One step towards this direction was to increase the tax on stock transactions from 0.1% to 0.3% by the Chinese government last week. A ministry official said the measure is intended to help promote the healthy development of the securities markets. This may possibly dampen the market in the short term, but the effect of stamp tax hike is yet to be seen. Historically, the Chinese ministry of finance has altered the stamp tax to exert its influence on the stock market and usually the hike in the stamp tax has triggered downturn in the stock market.

It was not just the Chinese government that was concerned with stock market frenzy, even the former fed chairman had expressed concern over Shanghai market few days back. Asia’s richest man, Li Ka-shing, had shared similar sentiments and also had mentioned that prices will decline. Of course, we don’t need an economist to tell us about this bubble, just because such a huge growth is unprecedented and needs extra ordinary support from the economy to sustain the growth.

So how much of correction to expect in Shanghai market? Is this going to be similar to that late February correction? Or is a long term slowdown looming ahead?

Nevertheless, the resiliency of bulls in recent days is so high, as witnessed by March recovery of late February sell off, that we may not see a big slump without any additional depressing information coming in. The US market did not even budge much from today’s Chinese market sell-off. I guess the US market has been learning to ignore short term noises, and only react to sustained pressures (so I hope). However, further slump in China can affect the US and rest of the world markets, as the markets are now so influenced by each other.

How can I trade this market? For bulls in the US, we can certainly look for a good dip in the next few days to get into emerging markets. For bears in the US, I am not sure if we have enough reasons to be happy about, other than the revised low GDP of 0.6% for first quarter and the usual suspect, Housing. However, below expectation results for the second quarter is possible and can potentially give a good boost for bears to take over for the remainder of the year.

I plan to do some work on possible trade setups with china sell off today and I will keep you all posted.

-Nidhi