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THE CHINESE GOVERNMENT’S strategy of pulling the wood from beneath the cauldron appears to be working. The precipitous fall in the Shanghai Composite Index is evidence of a market coming off the boil. In Beijing, there is much discussion about whether this cooling has exceeded its intended targets. However, the Beijing traders and investors I have been talking with in the last few days are beginning to agree that the worst is over. The developing Relative Strength Index (RSI) divergence pattern supports their growing confidence.
China’s growth rate is likely to slow from a blistering 11.9% in 1Q to a more manageable 9.5%. A return to 9.5% brings the market back to China’s average annual growth rate over the past decade. This will help to manage the inflationary and speculative- property-bubble risks. A sustainable and manageable growth rate will help China’s transformation from an export-based economy to one based on significant domestic demand.
Markets move in anticipation of changes in economic fundamentals. Patterns of market behaviour capture the turnaround in investor sentiment. Some technical indicators point the way to an increased probability of change developing, but it is the patterns of behaviour shown on the chart that confirm the trend change. Last week, we had a technical indication and we are waiting for the pattern confirmation.
The Shanghai Index has developed a delayed RSI divergence. It is a weaker form of RSI divergence, but it sends a good signal that a new market uptrend can develop. The RSI divergence signal is not useful for setting the exact time of the market reversal.
The RSI signal is a delayed signal because the low in the RSI does not occur at the same time as the low in the index. The RSI low developed on May 7. The low of the Shanghai Index developed on May 21. There is a two-week difference between the signals. This is unusual and suggests that traders need to exercise caution as the trend rebound develops.
The divergence pattern is also a weaker form of RSI divergence. The strongest RSI divergence is when the trend line on the index moves in the opposite direction to the trend line of the RSI indicator. In the current situation, the trend line on the Shanghai Index chart is down. The trend line on the RSI chart is horizontal. This is a good RSI divergence signal, but it often indicates the trend breakout is weaker.
A strong RSI divergence often leads to a V-shaped market recovery pattern. The weaker divergence often develops into a consolidation, followed by a rebound. In this situation, traders look for these conditions:
- A strong move above the downtrend line, followed by a retreat. The retreat uses the downtrend line as a support level;
- The pivot-point low of the downtrend is used as a new support level. This is a re-test of support near 2,480; and
- In some situations, the market may fall lower than the pivot-point low and use a historical support area for the consolidation rebound. The market continues to slide down the downtrend support line until it finds strong support. The next support area for the Shanghai Index is near 2,300. This is the upper edge of a long-term historical consolidation band.
The Shanghai market has been dominated by the long-term equilateral triangle pattern. The chart pattern is used to calculate the potential downside targets. The triangle projection value gives a downside target near 2,200, which is in the middle of the historical breakout trading consolidation band area. This combination of support and pattern target features suggests the index may dip quickly towards the 2,200 level before developing a consolidation pattern.
The RSI divergence suggests the downtrend is weakening, but it does not show the conditions necessary for a rapid trend rebound. The momentum of the downtrend is reduced, so we now watch for the development of a consolidation area and pattern. The consolidation pattern could develop as a trading band or as a short term cup pattern. (See Chart)
