Is The Chinese Equity Bull Market Over?

• 25-day ROC experiences a mega oversold.
• Shanghai Composite rallies from 200-day MA.
• In 1929 in the US and 2007 in China, stocks retraced 50% of their first bear market decline. What does that say about today?

This week I am focusing on the Chinese equity market since events in China could have an important spill-over effect on to US equities. Also, the decline at the beginning of last week caused quite a bit of selling in the commodity markets as commodities such as Copper are used in China as collateral and needed to be liquidated.

Right now there seems to be an almost universal opinion that despite numerous attempts at lowering margin requirements and suspending a huge number of stocks from trading etc. the authorities have lost control of the Chinese equity market. Prices, so the argument goes, are inevitably headed lower as it is not possible to rig markets forever by keeping prices above their natural level. I am inclined to agree with this sentiment in principle. After all, the Shanghai Composite ($SSEC) rose by about 150% between August of last year and June of this year, yet the OECD Leading Indicator for China sank throughout this period and is at a new cyclical low as we speak.  The advance was based on hope rather than reality. Markets are nothing more than people in action and this means that trends can extend beyond normal reality. However, at some point psychological gravity takes hold and every irrational situation finally comes back to ground.

One reason why we might be interested in a Chinese turnaround comes from the fact that in the last year or so China has been leading the rest of the world both on the upside and downside. The arrows in Chart 1 show that this is not a perfect relationship as the leads and lags differ and are occasionally absent. However, if the KST for the Shanghai Composite in the top panel were to reverse to the upside I believe that would be a good omen for the US.

Chart 1

The Primary Trend

Chart 2, shows that the price remains above its 12-month MA. Also, the long-term KST continues in a rising mode. These are two objective measures that I use for identifying primary trend direction. Another piece of missing bearish evidence is the lack of a series of declining peaks and troughs. So far we have the June/July drop and that’s it. In order for this technique to turn bearish we would need a rally that retraces at least a third of that decline followed by a move below last week’s low.  Such action would also likely crack the 12-month MA.

Chart 2

Chinese Mega Oversold Condition

Having said that, there is one technical piece of evidence that supports the idea of a new bear market, and that comes from the recent action on the 25-day ROC. By way of explanation, it’s a known fact that momentum indicators reflect sentiment and for this reason, change their character between bull and bear markets. One of those characteristics comes from the formation of mega conditions. A 'mega oversold' condition develops when a market has been in a primary bull trend for some time and the oscillator in question reaches a multi-year or even a record oversold condition. This multi-year oversold needs to be lower than anything seen in the previous bull or bear market. Chart 3 shows that last week the 25-day ROC fell to a level in excess of -30%, a mega oversold condition in fact. In my book, The Definitive Guide to Momentum Indicators, I point out that the mega oversold is typically the first decline in a bear market, but occasionally it can also signal a change in trend from up to sideways. In either case the bull market is over and the mega oversold signals that.

I should point out this condition is just one piece of evidence that points to a bear market and that as long as the longer-term moving averages remain intact we maintain a positive stance.  What the mega oversold is telling us is that Chinese equities may very well be in a bear market but that we should be on the lookout for any suspicious technical action if and when prices work their way higher.

Chart 3

One important characteristic about any market trend is that it is very rarely a straight line affair and is usually of a zig zag nature. So far we have only seen a 30% decline with no countervailing retracement rally. Not to get overly dramatic, but Chart 4 shows that even the 1929 bear market experienced a strong retracement rally that clawed back 50% of the initial decline. That advance lasted for five months between November 1929 and March of 1930. The signal of the resumption of the bear market was triggered by a penetration of the red head and shoulders neckline at 260.

Chart 4

Turning to another bubble peak, that of 2007 in Shanghai, we can see that the 2007 peak was followed by an initial decline into December and the ensuing rally retraced 50% of the lost ground. Note that during this period the 4300 level was an important one for both support and resistance.

Chart 5

If last week did represent the end of the initial panic what should we expect to see? One guide we get from 1929 and 2007 is for a 50% retracement. If that were to repeat, and I am certainly not forecasting such a move, the Index would find resistance at the 4,300 area that same level that was pivotal in the 2007-8 decline.

Chart 6

If last week’s low represents the termination of the June/July decline we would expect to see some form of selling climax as was the case in October 1929 (see Chart 4). Unfortunately StockCharts does not provide us with Shanghai volume but we can use two key Chinese ETF’s as a US volume proxy.  These are the FTSE China 25 Index (FXI) and  Market Vectors China (PEK). Both experienced a surge of volume last week following which prices bounced. If this is a bottom I would expect to see some digestion of the Thursday and Friday gains prior to prices moving higher.

My conclusion is that the Chinese equity market is still in a primary uptrend and has most probably hit a bottom of some kind last week.  As long as the Index remains above its 200-day and 12-month MA’s, we should give the benefit of the doubt to the bulls. However, if the anticipated advance reaches the 50% retracement level (i.e.4,300), that would be as good a place as any to look around for some corroborating evidence of a retracement rally peak and from there we can re-assess the true direction of the primary trend.

Chart 7

Chart 8

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group or its affiliates.