A Classic Technical Signal: China Breaks Down   (June 9, 2011)

China's stock market has broken a long-term flag to the downside. Look out below.

Since "the China Story" is the foundation of global growth, demand for commodities and ultimately, stock market profits, when China's stock market breaks down it behooves us to pay attention. Technical analysis offers a number of tools to help us chart the past and present and calibrate probablities of what might happen in the future.

Much of the time there are no clear signals, and chartists can lose their way trying to discern patterns and trends which may or may not pan out in the future.

In other cases, the technical tools provide very clear signals which investors choose to ignore at their own risk. These include "death crosses" (a short-term moving average dropping through a longer-term moving average) and price sinking below moving averages.

One classic pattern is a flag or pennant (a.k.a. a wedge). The psychology behind the pennant is rather transparent. Lower highs reflect a decline in Bullish enthusiasm and buying pressure, as every "buy the dip" fails to match the previous dip-buying.

The Bullish "story" that powers the "buy the dip" buying has rendered Bearish sellers wary, so each decline is shallower than the last. The tug of war between Bulls (buyers) and Bears (sellers) has reached a stalemate.

Whichever way the market breaks from this price/volatility compression sets the new trend's direction.

The direction of China's market has been decisively signalled: breakdown. In technical analysis, it doesn't get any better than this:

In the typical course of things, price may well rise in another "buy the dip" phase, but it will meet strong resistance at the lower trend line. Price may well noodle around for a while beneath this new resistance before cascading to previous lows.

Since the Shanghai market tends to lead the U.S. and other global markets, a breakdown in China's market can be seen as a predictor of what lies ahead in the U.S. and other global stock markets.

The wheels are falling off the China story. A massive wave of malinvestment since 2008 is cresting, and the stupendous stimulus provided by gargantuan local government and private lending is expiring.

That's what the chart is telling us if we "read between the lines."

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