Are These Exploding China Stocks a Broader Market Warning?

Over the past three weeks, a collection of small cap Chinese stocks that trade on US exchanges have been moving higher on increasing volume and attention from traders who seek the upside volatility.

Names like Vision China Media (VISN), China Cache International (CCIH) and Gulf Resources (GURE) have rallied 100% to 900% during October alone.

This represents a level of speculation in illiquid names that should at least give investors pause as they ride this broader market rally to new all time highs as, even within a bull market, sentiment tends to overheat periodically presaging a pull back in stocks.

Recall that in 2011, a basket of speculative Chinese stocks also went bananas and as they rapidly deflated, a broader market correction followed.

I checked in with Zor Capital's Frank Zorrilla to get a sense of what a seasoned momentum trader might glean from the conspicuous ebullience. Frank, has been trading momentum stocks since the NASDAQ bubble days and he always has a beat on the timing of the trade and the fade.

I asked Frank a few questions about this China small cap moonshot:

Frank, what's going on here with these China names?

Some of the larger Chinese stocks like YY Inc. (YY) and Vipshop Holdings (VIPS) broke out in early September. They are speculative to some degree in their own right, but more recently we are beginning to see the smaller caps run and these are less liquid. They can run and have really gotten going. Stocks like CCIH, BORN, EJ, VISN and GURE can double or more in a few days.

Is this a signal to get out of the market?

The moves in these China small caps is a concern and if you are just beginning to get long them now, I think you are too late in the game for that. They are volatile to begin with but after the moves we have already seen, there's as much risk to profit taking as anything else and because they are illiquid, they can move lower with equal or even more velocity than you get on the way up.

That being said, I'm not too quick to generalize the euphoria we see here to the market as a whole. We've seen divergences all the way up and in that way this has been, not only an historic rally, but a peculiar one as well. You get lighter than average volume and the broader indices keep going higher. You get moves in these junk names and the broader indices keep going higher. I'm not attending to divergences as much any more, simply because they haven't been working. So maybe these stocks are a signal but maybe they're not, and the when is impossible to tell at this point.

Plus, hedge funds are still heavily short the market and they have been wrong like clockwork over the past two years.

So what next then?

Well, you could get the correction here but I wouldn't be surprised to see some of these dry shippers stocks start to go. That would be the next logical step after the China names fall back down.

Thanks Frank.

Thanks Phil.

I'd only add that this morning's American Association of Individual Investors (AAII) Sentiment Survey is finally showing signs of unusually high optimism among investors with a 4.9% increase in bulls week over week to 46.3%, a three month high. This dovetails well with the Chinese stocks as contrary indicator thesis, though, as Frank pointed out above, the divergences hav not been working. Perhaps these are more just a first hint of caution even as the market notches new highs.