A rally is always something to get excited about, particularly after a market fall of around 50%. And that's exactly what Chinese stocks are experiencing at the moment. The Shanghai Composite Index is up 17% the past week due to strong earnings results and the reduction of stamp tax duties on share trading.
However a rally is not a trend change, so traders need to apply caution. It takes time, and money, to turn around a falling market. The attitude of investors is the most important feature of a market turnaround. We track their behavior using the long term group of averages in the Guppy Multiple Moving Averages (GMMA) indicator. When we look at the SCI chart we see that investors are not yet convinced this market downtrend has come to an end.
The long term group remains well separated. Despite the substantial rally rise there is no compression in the long term group of averages. This suggests investors used this rally as an opportunity to sell. Had they used this rally as an opportunity to buy then we would see a compression in this long term group.
But all is not lost. This sharp rally from the long term support near 3,000 is an important beginning of a potential trend change. It's not entirely unexpected. Several weeks ago traders observed a Relative Strength Index (RSI) divergence. This is a leading indication of a trend change. It has a high level of reliability, but one serious flaw. It is a leading indicator, but it gives no clue to the timing of the trend change. We expected the trend change to develop near the 3,000 level.
The 3,000 support level is an historic level, and also a downside target level calculated using the head and shoulder pattern. The market rally in the last few days does not mean the downtrend has ended. This remains a difficult and dangerous market. When the market reaches this level, traders look more carefully for evidence of chart patterns that show the downtrend has weakened.
Traders look for these features:
- Several successful tests of the support level
- The development of patterns such as saucers and rounding bottom patterns that confirm the end of the downtrend
- New rally behavior. Each rally must move higher than the previous rally
- The index must move above the important downtrend lines
- The index must move above the most recent strong support level. This is a new resistance level.
The resistance features are most important. They are a barrier for the current rally. Resistance is near 3,600. This is also currently the value of the lower edge of the long term GMMA. This rally will find strong resistance near 3,600 so we expect a retreat to develop.
A retreat that uses the downtrend line as a support level is bullish. The index may continue to slide down this trend line until it reaches historical support near 3,000. This is a bullish result because it shows the trend line has changed to a support line. The next rally will develop from this level. A strong bullish rally will penetrate into the long term GMMA group of averages.
This rally behavior is the beginning of a potential change in the trend. This trend change is confirmed when the long term GMMA shows evidence of compression. This tells us that investors are entering the market as buyers.
A retreat that falls below the downtrend line is bearish. This shows that the downtrend line will continue to act as a resistance level. This type of bearish retreat is a strong threat to the support level at 3,000. In this situation there is the potential to test the lower support level near 2,900. This could be a very fast index fall, followed by a fast rebound.
This rally has the potential to be the beginning of a series of higher rallies that will lead to a new uptrend development. The behavior of the market near support at 3,000 to 3,200 in the next two weeks is critical. Traders watch for confirmation the support area is strong.
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