Over the past few days I have often referred to stock markets being overvalued on fundamentals, overbought on technicals and overbullish on sentiment. This resulted in my call for caution until such time as the risk/reward ratio adjusted to more favourable parameters.

Following investors' concerns about China's policy response to inflationary pressures of higher interest rates and tighter credit conditions, the Shanghai Composite Index this morning declined by a further 2.9%, making the cumulative loss since the November 8 highs 15.3%. The Index is trading solidly below its 50- and 200-day indices and is mapping out a pattern of lower highs and lower lows - pretty ominous.

Source: StockCharts.com

I will comment further on the Chinese PMIs over the next few days, but just want to alert you to the fact that the Shanghai Composite Index historically leads the Chinese PMI by about a month and is probably pointing to a weaker PMI in January - precisely what I have been warning about regarding seasonality and the influence of the Chinese Golden Week.

Source: Plexus Asset Management; I-Net Bridge.

My concern is that, just as we experienced at the trough of the credit crisis, China, India, Brazil and some other countries are again leading the rest - this time by tightening first in reaction to the inflationary pain created by global money printing before these conditions spill over to the U.S. and Europe.

In the meantime, a few stock markets such as Germany and Sweden yesterday gave key day reversals, with the U.S. markets showing a serious deterioration in breadth. Also, American small caps dropped by twice as much as the S&P 500 to indicate relative weakness in this economically sensitive group (see relative strength chart in bottom section below). Small caps often lead the broader market at turning points.

Source: StockCharts.com

China and small caps - are these the proverbial canaries in the coalmine? I suspect so, especially given the overvalued, overbought, overbullish condition of stock markets. I guess it is safe to say that the odds of a pullback / correction are pretty good, hence warranting extra caution, including tight stops and taking long positions on volatility with instruments such as VXX and VXZ (iPath S&P 500 VIX Short-term Futures ETN and Mid-Term ETN) to capitalise on "risk off" sentiment.

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