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Shanghai Index Next Support Level 2,300: Charts

The Shanghai Index has fallen some 20 percent from the April highs. Industrial production has fallen between 13.5 percent and 15.5 percent year on year in August and for some this is reason enough to talk down the China market using the same metrics of analysis as applied to European and U.S. economies.

GUPPY RESIZE 0410.png

GUPPY RESIZE 0410.png

This fails to recognize the essential differences between the Chinese economy and Western economies. For investors this provides good investment opportunities as businesses that do business with China are unnecessarily sold down on this misinformation, some of which are trading at attractive lows.

Western economies have the problem of initiating growth. China has the opposite problem. China has to reduce the speed of growth to tackle inflation. It’s an application of the classic strategy of pulling out the wood from beneath the cauldron.

It cools a fast moving economy and this is showing up in PMI figures. It’s easy to forget that a China PMI reading as low as 48 is still equivalent to around 12 percent growth.

That’s a long way from the 1-2 percent growth hoped for in the U.S. When Chinese growth slows it is not a sign of economic collapse – it’s a sign of a controlled soft landing. When U.S. growth slows it’s at the other end of the growth spectrum and it is A sign of significant problems.

The most important change in the Shanghai Index has been the fall below the low created on August 9. There was a high probability the market would move lower and test the long-term support level near 2,300.

One of the leading indicators of a trend change is the development of a Relative Strength Indicator divergence pattern. There are several steps in developing a valid RSI divergence. The first step in identifying an RSI divergence pattern is to locate two valid valley lows on the index chart. The first valid low is the valley low created by the August 9 fall and rebound. A second valid valley low has not yet developed.

Traders watch the current fall in the market and look for a rebound from near 2,300 to develop the second valid valley low. When there are two valid valley lows on the index chart then the RSI chart display is investigated to see if it also has two valley lows under the 30 percent line on the RSI indicator. It is these two valid valley lows, associated with the valid valley lows on the index chart that create the conditions for an RSI divergence.

This has not yet developed. The current RSI indicator activity confirms the momentum of the downtrend is slowing but it does not yet suggest that the downtrend will turn into an uptrend. Historical support on the Shanghai Index is near 2,300 and the market is moving slowly towards a test of this level.

The index will close higher at the end of the week after the holiday break. Sometimes this can be a very rapid fast moving rally similar to the October 2010 rebound. This developed after a sideways consolidation pattern.

The current market is different from 2010 October because it has a well-established downtrend so the rally has several resistance levels to overcome. The first and strongest is near 2,600. A reduction in China’s monetary tightening has the potential to create a market rally with 20 percent upside or more.

This is a move from support around 2,300 to resistance around 2,800. This takes the market back to July highs and leaves the higher April highs near 3,000 well within reach for a 30 percent return. Investors are waiting for evidence support can hold and develop a base for a market recovery.

The Shanghai Index has a strong history of V shaped rebound behavior so aggressive investors will be ready to enter the market when first evidence of a rally rebound from near 2,300 develops.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.com. 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. We welcome all questions, comments and requests.

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