WHERE IS THE bottom for the Shanghai Index and is the current rally the beginning of a new uptrend? These were the two key questions I was asked when I visited Beijing recently. The answers can be inferred from chart activity on the Shanghai Index and the broader thrust of government policy decisions related to the slowing of the economy as part of the battle against inflation.

This year brings with it a range of external pressures ratcheted up by an election year in the US. The visit by US Treasury Secretary Timothy Geithner is a foretaste of what is to come. Secure in its own oil supplies despite threats in the Straits of Hormuz, the US has no problems in telling China to cut back on its oil imports from countries that the US does not approve of. No suggestion is made for substituting lost oil supplies from other sources. It plays well for US politics, but in the midst of a cold winter it plays less successfully in China.

 

A reduction in oil supply would have an inevitable inflationary impact and this is something that Beijing is keen to avoid reigniting. The consumer price index for December came in at 4.1%, marginally higher than market expectations of 4%. However, it is a significant reduction in the rate of inflation and opens the door to more liberal monetary and fiscal policies. That may be required to offset the twin pressures arising from continued US calls for renminbi appreciation and the slow collapse of European economies.

 

The US continues to see an appreciation in the renminbi as a panacea for its economic ills. The beauty of this solution is that it requires the US to do nothing to improve or adjust economic and manufacturing practices. However, it does make Chinese exports more expensive in US dollar terms and US dollar imports into China cheaper. Cautious moves will continue with renminbi appreciation, but the reaction in the face of increasingly strident US demands driven by electoral hysteria may in fact slow the pace of renminbi appreciation as China seeks to “preserve face” by not reacting to US pressure. It’s a subtle game unsuited to the brashness of US politics.

 

Also, look forward to an increase in the potentially damaging tit-for-tat trade wars with punitive tariffs making more frequent appearances. The lessons of history are selectively ignored in election years — it is easy to forget that this type of beggar-thy-neighbour tariff game tipped the world into the Great Depression in 1930.

 

Top this off with Washington’s proposed trade agreement that appears almost specifically designed to contain China and there is the potential of serious economic damage in China. It’s probably not enough to unseat China’s position as the world’s second-largest economy but it may be enough to inflict collateral damage on economies such as Australia, which rely heavily on continued Chinese prosperity.

 

Faith in the solidity of the Chinese economy is counterbalanced by the growing sense of external constraints on growth. On balance, the activity on the Shanghai Index suggests developing confidence in the ability of the Chinese economy to survive these external threats. This is partly what was driving the powerful rally seen recently. 

 

There are five key features in the behaviour of the Shanghai Index. They provide the environment for the development of a downtrend breakout for the index. The features are:

Trend line A starts with the high near 2,820 on July 18, 2011. This downtrend line acted as a resistance level until Oct 26, 2011. The breakout above the value of trend line A signalled the start of the 2011 rally from October to November. Now, trend line A acts as a support level.

 

Trend line B starts from the high near 3,070 on April 18, 2011. It uses the high of 2,820 on July 18, 2011, and the high near 2,530 on Nov 14, 2011, as the location points for the downtrend line. This is the long-term downtrend line and it acts as a resistance level. A breakout above the value of this downtrend line is very bullish. Current value is near 2,340.

 

The current rally is testing the support/resistance level near 2,300. A move above this level is bullish. A retreat away from this level is bearish and confirms the downtrend remains very strong.

 

The strong historical support level is near 2,000. The market may develop a consolidation band between 2,000 and 2,300. Activity inside this trading band could contain high volatility with very fast rallies and retreats. This is the danger in the current market with the potential for a rapid retreat from resistance near 2,300 and a retest of support near 2,000 to 2,150.

 

The long-term GMMA shows investor thinking and this remains well separated. This suggests investors are sellers in this market and they will help create the retreat from the 2,300 resistance level. The most important behaviour is compression in the long-term GMMA because this shows investors are becoming buyers. This is a bullish behaviour and confirms the development of a new uptrend.

 

Market rebounds develop in four main types of patterns. They are:

The strong resistance features near 2,300 and the value of trend line B suggests the Shanghai Index will retreat. A small retreat is bullish because it is easier to retest the resistance levels. A strong weekly close above trend line B near 2,340 is very bullish and will signal the start of a new uptrend. (See Chart.)