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What Now for Dow? Look to China for Clues

Tuesday, 20 Oct 2009 | 3:18 AM ET

Who follows and who leads in markets? The answer is surprisingly different to the answer most people assume is correct.

Intermarket technical analysis is a useful strategy tool for asset allocation. Its also a useful tool for working out what may happen in the future. Its too easy to look at markets in isolation, or to use outdated assumptions about market relationships. This is lazy thinking and in a changing market environment it can cost a fortune.

We publish hundreds of charts each year in our financial newsletter publications and in columns for international and Chinese financial media. The chart below is the probably the single most important chart you will see in 2009. You will need to put aside lazy thinking and assumptions to fully understand it.

This is not a technical chart. It’s a simple combination of 3 indexes, each displayed as a single line. Unlike many comparative charts the indexes have not been rescaled to a single starting point so we can see relative performance in percentage terms. This is not the significant feature of this information.

The charts have been time adjusted so it is easier to compare the behavioural characteristics of the three markets.

We use the Dow Index and the Australian ASX S&P 200 index (XJO) as representative of markets outside the US. The DOW and XJO charts have been time shifted to the left so the absolute market lows of March 2009, match the time of the absolute market low in the Shanghai Index in October 2008. This type of time shifted display clearly shows which market is a leader and which markets are followers.

This chart display confirms that 2009 has seen the most profound change in market dynamics in more than half a century. Put simply, China leads and the DOW follows.

The blue line shows the performance of the DOW index.

The black line shows the performance of the Australian ASX S&P 200 index.

The red line show the performance of the Shanghai Index.

The DOW is now at 10,000 but how important is this in terms of global market behaviour?

The DOW is following the behavioural leadership of the China market.

The 10,000 equivalent for the Shanghai Index is 3,000. The Shanghai market reached this level and briefly powered above it before developing a trend correction.

The Shanghai Index remains in trend correction mode and is using price and time corrections. The price trend correction is the sudden index fall of between 15% to 20% from 3480 to 2750. The time correction for the trend is the extended sideways movement over the past 10 weeks.

The important relationship is not the comparative percentage returns, but the comparative behaviour. We need to watch carefully because there is a high probability our markets and the US market will follow this China market leadership behaviour with a lag of several months.

This suggests a trend price correction in the order of 10% to 15% followed by a period of sideways trading as the market applies a further trend correction using time.

Analysing and understanding China market behaviour is absolutely critical to any market strategy. China leads, the DOW follows the behaviour and other markets tag along further behind. Watching China gives investors a glimpse of the potential future. It is absolutely essential to developing any long term portfolio investment or planning.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.

CNBC assumes no responsibility for any losses, damages or liability whatsoever suffered or incurred by any person, resulting from or attributable to the use of the information published on this site. User is using this information at his/her sole risk.

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