Is the current rally the beginning of a new uptrend for the Shanghai Index? This was one of the key questions I was asked when I was in Beijing earlier this week.
The answer can be got from chart activity on the Shanghai Index and from the broader thrust of government policy related to the slowing of the economy and to the battle against inflation.
There are five key features in the behavior of the Shanghai Index . These features provide the environment for the development of a downtrend breakout for the Index. The features are:
Trend line A acted as a resistance level until October 26, 2011. The breakout above the value of trend line A signaled the start of the 2011 rally from October to November. Now trend line A acts as a support level.
Trend line B is the long-term downtrend line and it acts as a resistance level. A breakout above the value of this downtrend line is very bullish. Current value is near 2,340.
The current rally is testing the support/resistance level near 2,300. A move above this level is bullish. A retreat away from this level is bearish and confirms the downtrend remains very strong.
The market may develop a consolidation band between 2,000 and 2,300. Activity inside this trading band could contain high volatility with very fast rallies and very fast retreats. This is the danger in the current market with the potential for a rapid retreat from resistance near 2,300 and a retest of support near 2,000 to 2,150.
The long-term GMMA shows investors thinking and this remains well separated. This suggests investors are sellers in this market and their selling created the retreat from the 2,300 resistance level. The most important behavior is compression in the long-term GMMA because this shows investors are becoming buyers. This is a bullish behavior and confirms the development of a new uptrend.
Market rebounds develop in four main types of patterns. They are: L-shaped consolidation. The strong rally towards 2,300 suggests this L-shaped consolidation pattern will not develop.
Saucer pattern. This pattern may develop so traders watch for the behavior of any retreat from 2,300.
V-shaped recovery. Looks like this pattern will not develop because the rally is moving too quickly.
Inverted head and shoulder pattern. The fast rally has changed the potential development of this pattern. A move above 2,300 and a retreat from the value of trend line B creates the conditions for an inverted head and shoulder pattern. Traders watch for the future development of the index behavior.
The strong resistance features near 2,300 and the value of trend line B suggest the Shanghai Index will retreat. A small retreat is bullish because it is easier to retest the resistance levels. A strong weekly close above trend line B near 2,340 is very bullish and will signal the start of a new uptrend. This remains a rally within the context of a downtrend, but it is also part of the context of a broad consolidation pattern.
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.
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