Written by Daryl Guppy

Monday, 26 July 2010 12:15

Written by Daryl Guppy

Monday, 26 July 2010 12:15

Written by Daryl Guppy

Monday, 26 July 2010 12:15

THERE WERE THREE significant market events developing globally last week. They were the continuing head-andshoulder pattern in the Dow, the breakout from sideways trading bands in regional markets, and the sharp rebound in the Shanghai Composite Index. Globally, they are all parts of the same behaviour that is tracking the transfer of economic power. The announcement that China is now the world’s largest user of energy confirms what markets already knew. True affluence arrives when China becomes the largest consumer of sugar per capita but that is many decades away. Currently, the US is the world’s largest consumer per capital.

Working with brokers and remisiers from DBS Bank during the week, I explored the impacts of the restructuring of the Chinese economy to service domestic demand. A pre-condition for robust and sustainable domestic demand is an increase in the basic wage. The Chinese government is firmly behind the latest round of wage increases and this is a policy shift that is as important as the injection of infrastructure stimulus in 2008. Higher wages fundamentally change the nature of the economy and its foundations.

 

Singapore’s first prime minister Lee Kuan Yew quickly recognised that future growth depended upon a skilled and educated workforce rather than an economy based on the lowest cost of production. Aspiring countries such as Vietnam and Laos can always undercut on the cost of production. China is abandoning this position with its move towards government sanctioned higher wages.

 

The result is to empower wage earners to increase their domestic consumption. This is consumer driven demand, not credit driven demand. This is a fundamental change in the direction and foundations of the economy and the effects are beginning to bear fruit in the behaviour of the Shanghai Index.

 

Starting last August, the Shanghai market developed an equilateral- triangle pattern. In April this year, the market fell below the lower edge of this triangle pattern. The pattern downside projection target was near 2,300. The market has developed a rebound from the low near 2,319.

 

Chart patterns and behaviour are constantly changing. Analysis always tries to identify the trigger points where the market moves from one condition to another. The Shanghai Index breakout above the support/resistance level near 2,480 is one of these trigger points. The developing behaviour has several possible paths to follow and it is not clear yet which path will be taken. The Shanghai Index is showing strong trend reversal behaviour, but the nature of the trend reversal is not yet confirmed.

 

The dominant pattern is the fan trend-line pattern. This is a series of trend lines that start from a single point. As the pattern develops, the trend lines act first as a resistance level, then as a support level. The pattern usually has between four and six fan trend lines. A retreat after the current rally will give the position of the fourth fan trend-line.

 

This market behaviour does not show a perfect fan trend-line pattern. The lower edge of the fan trend pattern is usually either a strong horizontal support level or a shallow saucer pattern. In the Shanghai Index, it is usually a horizontal historical support level. The current index activity has not developed a horizontal support level, so the fan trend-line pattern is not exact.

 

The potential developing pattern is an inverted head-and-shoulder pattern. The left shoulder was created on May 21 with the low at 2,481. The head of the pattern was created on July 2, with the low near 2,319. The devolvement of this pattern is most easily seen on a weekly chart.

The right shoulder would be created in the future with a retreat from the current rally and a retest of the support area near 2,480. The inverted head-andshoulder pattern is a powerful trend reversal pattern. The Shanghai market downtrend reversal in 2009 also developed an inverted head-and-shoulder pattern.

 

It is too early to confirm the inverted head-and-shoulder pattern and it is not possible at this time to decide where the neckline should be located. This is a potential pattern that may develop. Investors should look for confirmation of this pattern in the next several weeks.

 

The Shanghai Index is developing behaviour that shows the end of the downtrend. The strong index breakout above 2,480 is bullish. Investors should wait for the rally to be followed by a retreat and successful retest of 2,480 as a support level. Strong penetration into the longterm group of GMMA averages confirms the beginning of a sustainable trend reversal. (See Chart)