Tuesday, August 4, 2009

Shanghai stock index: How far to go?

It’s been a while since I posted anything using technical analysis. Back in early April, I had written about the 50 day 200 day Moving Average crossover in the Shanghai Stock market. I think we should look at the Shanghai index as a ‘leading indicator’ to gauge US markets. This crossover happened a good 2 months before the US markets did. We also got an early non-confirmation of the March lows when the Shanghai index failed to make a new low at that point of time. (Though of course volume and breadth were other valid non-confirmation signals as well).

Since I believe this is a cyclical rally in a secular bear, I wanted to use Fibonacci analysis to gauge the retracement levels in the Chinese markets. This basically gets you an idea of how far this bear market rally retracement should go. While you might not believe in Fibonacci or technical analysis, it's still useful to keep these levels in mind as selling and buying pressure would appear around these levels from people following these trends. As can be seen from the chart below, we’ve already crossed the 38% retracement level, which means the 50% retracement at 3800 on the Shanghai Index is in play. This suggests further upside ahead.

Since we’ve crossed the 38% retracement on the Shanghai index, I expect a similar move on the S&P 500 as well. A similar 50% retracement on the S&P 500 gets us to 1100, which suggests the stock rally should go through the 1000 level. (Note: I wrote this up on Sunday)

Babak points out the over-extended nature of the current rally, and the similarity to the speculative blow-off of October-November 2007. The RSI indicator in the chart is also similarly showing an overbought reading in excess of 70. This marked the top during the previous bull run. However, the overbought conditions became even more overbought, and stayed that way before the markets corrected. In fact, the Shanghai market went up more than 100% after registering RSI readings in excess of 70!!

Note also the similarity of the 1 day 7% decline last week to the February 26th, 2007 one day decline of 8.8%. (John Authers talks about this in FT.) The Shanghai markets continued rallying for the next few months after the decline in February 2007.

Add in the recent Dow Theory buy signal, and investor bullishness should persist. Ebulient animal spirits are back in vogue.

All this suggests that it’s not yet time to play the markets on the short side (except maybe for a multi-week short-term pull back).

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