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Guest Post: A Classic Technical Signal: China Breaks Down

Tyler Durden's picture




 

Submitted by Charles Hugh Smith from Of Two Minds

A Classic Technical Signal: China Breaks Down

China's stock market has broken a long-term flag to the downside. Look out below.

Since "the China Story" is the foundation of global growth, demand for commodities and ultimately, stock market profits, when China's stock market breaks down it behooves us to pay attention. Technical analysis offers a number of tools to help us chart the past and present and calibrate probabilities of what might happen in the future.

Much of the time there are no clear signals, and chartists can lose their way trying to discern patterns and trends which may or may not pan out in the future.

In other cases, the technical tools provide very clear signals which investors choose to ignore at their own risk. These include "death crosses" (a short-term moving average dropping through a longer-term moving average) and price sinking below moving averages.

One classic pattern is a flag or pennant (a.k.a. a wedge). The psychology behind the pennant is rather transparent. Lower highs reflect a decline in Bullish enthusiasm and buying pressure, as every "buy the dip" fails to match the previous dip-buying.

The Bullish "story" that powers the "buy the dip" buying has rendered Bearish sellers wary, so each decline is shallower than the last. The tug of war between Bulls (buyers) and Bears (sellers) has reached a stalemate.

Whichever way the market breaks from this price/volatility compression sets the new trend's direction.

The direction of China's market has been decisively signalled: breakdown. In technical analysis, it doesn't get any better than this:


In the typical course of things, price may well rise in another "buy the dip" phase, but it will meet strong resistance at the lower trend line. Price may well noodle around for a while beneath this new resistance before cascading to previous lows.

Since the Shanghai market tends to lead the U.S. and other global markets, a breakdown in China's market can be seen as a predictor of what lies ahead in the U.S. and other global stock markets.

The wheels are falling off the China story. A massive wave of malinvestment since 2008 is cresting, and the stupendous stimulus provided by gargantuan local government and private lending is expiring.

That's what the chart is telling us if we "read between the lines."

 

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Thu, 06/09/2011 - 10:05 | 1354245 TSnew
TSnew's picture

That break down is only on the LOG chart. On the regular scale, we are at the bottom of the flag, but it's not broken. 

Thu, 06/09/2011 - 10:37 | 1354314 Burnsy
Burnsy's picture

You should always use log charts for longer time frames.

Key points on the benefits of arithmetic and semi-log scales:

  • Arithmetic scales are useful when the price range is confined within a relatively tight range.
  • Arithmetic scales are useful for short-term charts and trading. Price movements (particularly for stocks) are shown in absolute dollar terms and reflect movements dollar for dollar.
  • Semi-log scales are useful when the price has moved significantly, be it over a short or extended time frame
  • Trend lines tend to match lows better on semi-log scales.
  • Semi-log scales are useful for long-term charts to gauge the percentage movements over a long period of time. Large movements are put into perspective.
  • Stocks and many other securities are judged in relative terms through the use of ratios such as PE, Price/Revenues and Price/Book. With this in mind, it also makes sense to analyze price movements in percentage terms.

 

Thu, 06/09/2011 - 11:01 | 1354427 jeff montanye
jeff montanye's picture

thanks.

Thu, 06/09/2011 - 11:26 | 1354516 Haywood Jablowme
Haywood Jablowme's picture

Dr Faber had stated several times that a breakdown in China might occur but it would also be one to recover the fastest...

Thu, 06/09/2011 - 14:24 | 1355155 Fat Ass
Fat Ass's picture

Busby, it's a big question.   Personally, I say linear charts only, for "charting."

If you go back to the source of all "chart reading," the early Japanese rice markets (I urge you to read Steve Nison's book in English), certainly the original "chartists" thought only of linear charts.

If you believe that "chart formations" are an expression of human group behaviour (which seems reasonably - i.e., you don't think they are caused by ghosts or the like) then it's hard to see how log charts can be relevant.

I say, stick to "normal" linear charts for "charting".

Thu, 06/09/2011 - 10:50 | 1354381 I am more equal...
I am more equal than others's picture

at the apex of doom...

 

O CAPTAIN! my Captain! our fearful trip is yet a head;     
The ship will not weather this storm, the prize we sought is lost;     
The port is far, the bells I hear not, the people all revolting,     
While follow eyes the keel, the vessel grim and sinking:     
    But O heart! unsteady! and dread!            
      O the bleeding drops of red,     
        Where on the deck my Captain lies,     
          Fallen cold and dead.

Thu, 06/09/2011 - 11:46 | 1354594 Highrev
Highrev's picture

The same thing has happened in the U.S.

ALL the major U.S. indices (except the RUT) have broken their uptrend lines drawn off lows on the semi-log charts, but not on the linear charts.

The timing of the "break" is also the same.

Rather than to leading the U.S., they look to be in sync to me.

 

Thu, 06/09/2011 - 10:03 | 1354247 PaperBear
PaperBear's picture

Gold/silver should NOT crash this time because there is plenty of liquidity apparently unlike in 2008.

Thu, 06/09/2011 - 12:46 | 1354814 lawrence1
lawrence1's picture

Im betting your are right, that also money may, in fact, flow into gold and silver this time.

In any case, why sell physical gold and silver for paper, even if the paper prices go down.... they will return with a vengeance.  My crystal ball.

Thu, 06/09/2011 - 10:09 | 1354255 Jason T
Jason T's picture

call me crazy but those investments in China will only lead to higher rates of productivity per capita per square kilometer and that will enhance china's wealth and standards of living.

 

i.e faster commute times, greater access to goods and services, higher quality of food, housing and healthcare.. etc.

They will also get a stronger currency.  

Thu, 06/09/2011 - 11:01 | 1354439 jeff montanye
jeff montanye's picture

disagree with the "only".  in the short term they may very well lead to deflationary depression.  the last two countries with as much relative foreign currency reserves as china today were the u.s. in 1929 and japan in 1989.

Thu, 06/09/2011 - 11:07 | 1354463 ElvisDog
ElvisDog's picture

I don't think empty shopping malls and shoddily-built apartment buildings will lead to higher rates of productivity. And those empty cities built in the Gobi desert - not so much.

Thu, 06/09/2011 - 10:09 | 1354257 Tense INDIAN
Tense INDIAN's picture

India WILL follow SHortly

Thu, 06/09/2011 - 10:51 | 1354399 rajat_bhatia
rajat_bhatia's picture

are you sure? the arseholes wont let it fall

Thu, 06/09/2011 - 10:13 | 1354260 Fortunes Favor
Fortunes Favor's picture

Tech analysis works in better in an mkt not manipulated. With all the intervention abound in all global mkts I would caution against being too bearish. The story below says it all...

How China Just Implemented A Stealth Bailout Bigger Than One And A Half TARPs http://ow.ly/5cgMS

Thu, 06/09/2011 - 10:26 | 1354285 Orly
Orly's picture

I have had this unfortunate experience as well, especially trading the EURUSD.  They can see sell signals, too, and will invariably make some "announcement" or simply start buying Euros to counter the technical pattern.

Frustrating.  But they can't keep it up forever.

:D

Thu, 06/09/2011 - 11:12 | 1354469 ElvisDog
ElvisDog's picture

I agree. I used to follow Richard Russell a lot with his Dow Theory analysis. But I've come to the conclusion that technical analysis like Dow Theory don't work in our computer age. The computer programs know all the technical signals and manipulate the markets to trigger them to suit their advantage.

Thu, 06/09/2011 - 10:15 | 1354264 RobotTrader
RobotTrader's picture

FXI bottomed today, and it could not take out the previous lows.

The end of those triangle patterns often result in a "false break", then a reversal.

Thu, 06/09/2011 - 10:43 | 1354370 Burnsy
Burnsy's picture

http://thepatternsite.com/at.html

"The ascending triangle performs best when the break is to the downside, and in a bear market."

 

On pages 711 to 729 of the book Encyclopedia of Chart Patterns, Second Edition, you can read the complete treatment of ascending triangles, including identification guidelines, focus on failures, statistics, trading tactics, and a sample trade.

The ascending triangle is a mediocre performer despite its reputation as a reliable chart pattern. In fact, the ascending triangle performs best when the breakout is downward, especially in a bear market.

Thu, 06/09/2011 - 11:16 | 1354477 GoingLoonie
GoingLoonie's picture

Correct, and given the massive amount of stimulus just inserted into the Chineese economy by their own Government, this should reverse as well.

Thu, 06/09/2011 - 12:57 | 1354843 lawrence1
lawrence1's picture

Read  The Misbehavior of Markets by Benoit Mandelbrot if you still believe in TA.  I prefer to read the discarded fruit seeds on sidewalks here in Nicaragua. They told me to empty my Fidelity Account, sell all paper, not to sell not even an ounce of physcal PMs regardless of the paper toilet paper dollar price.  And I read the seeds with my eyes closed.

Thu, 06/09/2011 - 10:23 | 1354292 Dismal Scientist
Dismal Scientist's picture

Technical analysis is for people who can't think for themselves.

Thu, 06/09/2011 - 10:31 | 1354306 Mec-sick-o
Mec-sick-o's picture

Haha, and fundamentals are great to rely on now?

Try your long position fundamentals and you will get burned.

Thu, 06/09/2011 - 10:33 | 1354318 Orly
Orly's picture

Sorry but that statement is just not very bright at all.

There are patterns because humans do the same thing over and over again.  It's what we do.

It's what we do.

Don't believe me?

http://www.zerohedge.com/article/here-it-comes-obama-considering-another-fiscal-package

Seems to me the real thinkers are the technical analysts.  While you spend hours looking at rosy-coloured submissions to the SEC, we can see what's really going on in about four minutes.

Good luck in your trading.

Thu, 06/09/2011 - 11:13 | 1354483 LawsofPhysics
LawsofPhysics's picture

The net result of trying to keep the sham going will be a continued destruction of real capital and all things paper for everyone, except those doing the manipulation.

I have moved everything to physical gold, silver, and purchased (with cash) more arable land (to be leased) and other revenue bearing assets (invested in a local brewery - agreed not to have a voice in decision making in exchange for dividend payments).  All things physical, especially assets that are revenue bearing, will be the place to be during the slow collapse (be it deflationary or inflationary).  With all the world powers deflating all fiat, on paper at least, it now becomes a game of "losing less" in terms of paper.  If you are holding/controlling assets of real value, you will be well positioned in terms of real wealth and buying power.

Thu, 06/09/2011 - 11:21 | 1354494 Orly
Orly's picture

Very well said.

One day, I hope to be able to follow your advice.

Thu, 06/09/2011 - 13:00 | 1354866 lawrence1
lawrence1's picture

Well put.  Get physical, stay physical, real stuff.

Thu, 06/09/2011 - 13:00 | 1354867 lawrence1
lawrence1's picture

Well put.  Get physical, stay physical, real stuff.

Thu, 06/09/2011 - 10:26 | 1354301 carbonmutant
carbonmutant's picture

Today's divergence with the Euro would seem to indicate a DCB...

Thu, 06/09/2011 - 10:38 | 1354332 GoldbugVariation
GoldbugVariation's picture

plus, the lower trendline on his LOG chart doesn't even go through the June 2010 lows properly - if it did do it properly, then (a) the lower trendline would not have been touched at the January 2011 low, (b) the lower trendline would be lower by now, so there wouldn't be a break - or certainly not a decisive break.

I would also question the strength of this type of precisely price-based signal on a composite index - I think it's a stronger indicator on an individual stock or commodity, where there are buyers and sellers at hard levels.

On the other hand, a more interesting observation may be that there is about to be a breakout from the triangle one way or another.

My current belief on technical signals of this kind is that they have no predictive power, because even though they may be accurate, say, 70% of the time, the money you lose on the other 30% of the time is big - to put that another way, I think a false breakout is actually an indicator that a big opposite move is coming.  Maybe good risk management can make these chart signals profitable but I never figured out a way to do it.

Thu, 06/09/2011 - 10:36 | 1354339 web bot
web bot's picture

This is not good.

Thu, 06/09/2011 - 10:45 | 1354365 Fred123
Fred123's picture

2700 is major support. Looks like a possible trading range is in play. I'd be long with a close stop. If break below 2700 I'd wait for a retest of 2700 to short.

I'm biased against China. Those folks would cheat anyone to get a yuan, not good for a long term economic prosperity. They will do themselves in.

Thu, 06/09/2011 - 11:18 | 1354487 LawsofPhysics
LawsofPhysics's picture

yep, U.S. mentality on steroids, WWIII?

Thu, 06/09/2011 - 11:45 | 1354603 Fred123
Fred123's picture

Ahhh......can't think beyond what the media tells you, eh Physics? I suggest you read up on your history a bit and maybe follow it up by living in Asia instead of in your mommies basement. You cannot dispute my claim so you post something stupid, which is typical of the brain dead folks that I've seen come out of the Western worlds education system in the last 40 years. Idiot is too kind of a word to describe folks such as yourself.

Thu, 06/09/2011 - 13:19 | 1354925 karzai_luver
karzai_luver's picture

as have we good buddy. as have we.

Thu, 06/09/2011 - 11:00 | 1354417 Anjum
Anjum's picture

I think its a false breakdown ... also, since the triangle had reached the apex point, it had to break either way and as such is mostly disregarded.

Thu, 06/09/2011 - 11:23 | 1354502 GoingLoonie
GoingLoonie's picture

Great Chart and good discussion.

Thu, 06/09/2011 - 12:08 | 1354691 jabba_67
jabba_67's picture

Absolutely correct, the wedge is not broken yet

Thu, 06/09/2011 - 12:19 | 1354732 dehdhed
dehdhed's picture

it's called a perfect technical signal but since it didn't break well within the formation and instead waited till the end, it's less than perfect.  these usually just target a support level and not a crash as the height would suggest .. imho

Thu, 06/09/2011 - 12:36 | 1354782 Mitch Comestein
Mitch Comestein's picture

I saw this pattern about 2-3 weeks ago.  I took the unders and am short.  QE 16 may screw up whole plan though.

Thu, 06/09/2011 - 13:06 | 1354888 Frank N. Beans
Frank N. Beans's picture

charts or no charts, nobody know anything, nobody knows what's gonna happen, it's all guesswork based on bias, history, and emotion.

Thu, 06/09/2011 - 13:17 | 1354926 thriftymost
thriftymost's picture

I predict that the sun will rise tomorrow morning.  I predict that it will peak around noon, and set some hours later.

I predict that 2011 will be followed by 2012.  I also forecast my own death, and yours as well, within the next hundred years, barring a general proliferation of life-extension technologies.

So you see, the future is not unknowable.  It's just not fully knowable.  Much like the present.  And the past.

Thu, 06/09/2011 - 13:19 | 1354930 karzai_luver
karzai_luver's picture

humans crave patterns.

dumber humans insist they are correct.

 

not much advanced from thowing da bones.

 

A fool witha chart can make you believe anything you wish to.

 

 

Thu, 06/09/2011 - 13:30 | 1354971 Biosci
Biosci's picture

You mean, just like every decision anyone has ever made about anything?

Thu, 06/09/2011 - 13:17 | 1354914 lawrence1
lawrence1's picture

I see flying wedges, moving at random accompanied by strong whiffs of black swans. This is my signal to open a diaper business and keep my PMs.

Thu, 06/09/2011 - 14:04 | 1355045 GoinFawr
GoinFawr's picture

Speaking of 'Black Swans', looking to expand my knowledge of unexpected economic events last night I watched a 2010 film with the same title... it certainly wasn't what I expected. OTOH, what with Mila Kunis and Natalie Portman 'wrestling' over who gets to be the Black Swan, I can now say that I have never seen a movie on the subject of ballet that I didn't thoroughly,vigorously enjoy.

Thu, 06/09/2011 - 13:46 | 1355014 Ying-Yang
Ying-Yang's picture

China will innovate its way out of trouble.... lookie here:

China Genetically Modifying Cows To Produce Human Breast Milk

Read more - http://www.myfoxny.com/dpp/news/china-genetically-modifying-cows-to-produce-human-breast-milk-20110608-ncx 

Now..that REALLY will SUCK... oh nevermind

Thu, 06/09/2011 - 14:11 | 1355096 Smokey1
Smokey1's picture

Unauthenticated specious garbage. China will continue to roll. All those who short China are fools, especially Chanos.

You could obtain as much statistical validity as the chart in this article by charting the patterns of cockroaches running across the kitchen floor, or rats running through a landfill.

Thu, 06/09/2011 - 14:21 | 1355145 laomei
laomei's picture

China does not rely on the stock markets to survive.  The financial industry is a miniscule portion of the GDP in China.  Furthermore the banks are state owned, so they do as they are told.  Any company or individual within China who manipulates the market is looking at a nice swift death sentence (literally) and China is very insulated from foreign speculators.  This isnt America, this isn't Europe... China will do what China needs to do for China to survive and it's really as simple as that.  Very few people bother with playing the market over here.

Thu, 06/09/2011 - 14:20 | 1355156 Orly
Orly's picture

Then why do American media try to make it sound as though every maid and every barber pumps all of their wages into the Shanghai Index?

Thu, 06/09/2011 - 15:00 | 1355302 Smokey1
Smokey1's picture

Because the American media eats shit.

Thu, 06/09/2011 - 15:30 | 1355391 10 Euro Münze
10 Euro Münze's picture

I work for a an automotive parts company and we have a plant in China.   A memo came out today saying that we have a 9% drop in sales over last year.    Customers are pulling orders from the books.  It was basicaly a warning to start watching costs as this could get worse.

Thu, 06/09/2011 - 15:40 | 1355429 hungarianboy
hungarianboy's picture

Oh really? I just checked but for me it bounced off support.

http://www.screencast.com/t/iCB66NkuM

 

Thu, 06/09/2011 - 16:00 | 1355484 dugorama
dugorama's picture

Remember the assumptions underlying a perfectly competitive market:

- infinite number of sellers (okay, close enough)

- infinite number of buyers (okay, close enough)

- perfect information (only by some, not incl you)

- low or no cost of transaction (dunno 'bout Shanghai, honestly)

and underlying these underlying assumptions:

fair and honest trading system supported by a fair and honest legal system (not even in your dreams)

 

Thu, 06/09/2011 - 23:13 | 1356865 ReardenMetal
ReardenMetal's picture

Markets often bottom in emotion-driven 'Vs', but tops are typically rolling and give sellers plenty of time to get out.

Fri, 06/10/2011 - 06:12 | 1357220 moneybookers
moneybookers's picture

the trend line was actually not broken yet if you draw it right.

Sat, 06/11/2011 - 06:41 | 1360849 chump666
chump666's picture

close to 6mths of shanghai weakness and the b index has just collased. china hard landing ahead

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