In the murky world of accounting, balance sheets, company announcements and company denials it is only chart analysis that provides a beam of light. The collapse of Sino Forest after an adverse report from short seller Muddy Waters came as a surprise to many. Certainly the degree and extent of the collapse was accelerated by the report, but the chart activity already provided several cautionary warnings.
The warnings did not specify the cause of concern. However the price activity clearly signaled caution for existing investors, and a warning for those thinking of entering the trade from the long side. The ideas of a warning, but no reason, makes many people uncomfortable with this application of charting analysis. We find it’s a very useful method, taking us out of stocks before they fall, and keeping us out of doubtful stocks.
Some markets are more opaque than others. Information flows more slowly, or erratically. Reports are confusing and numbers massaged to within an inch of outright lies. One only has to look at the audit records of companies such as Enron in the US, or ABC Learning in Australia. They were given glowing audit endorsements in the weeks prior to their dramatic collapses. Each of these had shown clear chart based warnings of impending doom.
The weekly chart of Sino Forest shows three significant warning features of a trend collapse. The first is simple trend line analysis. The short term uptrend was defined with the trend line. On a weekly chart it is preferable to use the lower edge of the candle for trend line placement. The move below the trend line was a clear indication of the end of the current up trend. The exit signal is near $22.00.
The second confirmation came from the Guppy Multiple Moving Averages (GAMMA) relationships. The compression in the long term group of averages confirmed that investors had joined the sell-off initiated by short term traders. The move below the lower edge of the long-term GAMMAs provided additional evidence of a major trend change. The exit signal is in the $21.00 area and gave traders a three week window of opportunity to get out.
The third and most powerful end of trend signal is generated by the Relative Strength Indicator. The RSI developed an RSI divergence. The trend line A1 on the price chart is moving upwards, capturing the new highs in Sino Forest.
Over the same period the trend line on the new peaks on the RSI shown as A2 is moving down. This is RSI divergence. It is a reliable leading indicator of a major trend change. Traders using this signal were ready to exit around $24.00.
This combination of signal gave exit points between $24.00 and $20.00. These were clear end of trend signals that got investors and traders out before the stock fell to $2.00.
Chart analysis cuts through the fog of confusion generated by obscured reporting, lax listing rules, poor regulatory regimes and those intent of fraud. It gives investors the opportunity to separate the wood from the trees.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.
If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com.
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