Shanghai Index as Leading Indicator of U.S. Markets

Includes: FXI, PGJ, SPY
by: User Gyaan

Back in early April, I had written about the 50 day - 200 day Moving Average crossover in the Shanghai stock market. I think we should look at the Shanghai index as a ‘leading indicator’ to gauge US markets. This crossover happened a good 2 months before the US markets did. We also got an early non-confirmation of the March lows when the Shanghai index failed to make a new low at that point of time.

Since I believe this is a cyclical rally in a secular bear, I wanted to use Fibonacci analysis to gauge the retracement levels in the Chinese markets. This basically gets you an idea of how far this bear market rally retracement should go. While you might not believe in Fibonacci or technical analysis, it's still useful to keep these levels in mind as selling and buying pressure would appear around these levels from people following these trends. As can be seen from the chart below, we’ve already crossed the 38% retracement level, which means the 50% retracement at 3800 on the Shanghai Index is in play. This suggests further upside ahead.

Since we’ve crossed the 38% retracement on the Shanghai index, I expect a similar move on the S&P 500 as well. A similar 50% retracement on the S&P 500 gets us to 1100.

Babak points out the over-extended nature of the current rally, and the similarity to the speculative blow-off of October-November 2007. The RSI indicator in the chart is also similarly showing an overbought reading in excess of 70. This marked the top during the previous bull run. However, the overbought conditions became even more overbought, and stayed that way before the markets corrected. In fact, the Shanghai market went up more than 100% after registering RSI readings in excess of 70.

Note also the similarity between the 1 day 7% decline two weeks ago and the 8.8% one day decline on February 26th, 2007. (John Authers talks about this in FT.) The Shanghai markets continued rallying for the next few months after this decline. Historically, the bear market rally of 1929-1930 also consisted of a 50% retracement back to 294, after the initial decline took the Dow from 381 to 198. Here’s an excellent FT piece on comparisons with other historical periods.

Well, turns out Fibonacci has really been in the news for retracement levels last week. For a list of sample instances, please refer to the link. While the absolute numbers might differ marginally, the upshot is the same. These levels are being watched by a huge number of investors.

The key point is that most commentators see the equity markets' upside capped at around 0-10% from here, but the downside is considerable, quite possibly retesting the March lows. Even the non-Fibonacci fundamentals driven consensus seems to be for at most a rally to around the 1,050-1,100 mark on the S&P 500. This suggests we’ll either:

a) go down around here, or

b) go right through 1100.

Consider the second case. If one were to look at all this Fibonacci analysis from a contrarian perspective, this might be bullish news. Just as the widely discussed head-and-shoulders pattern turned out to be a head fake and the equity markets rallied sharply, the current consensus using Fibonacci retracements could be a bullish omen.

To paraphrase the Bespoke group, with so many market and economic indicators reaching pre-Lehman levels, one has to ask: will the markets be next? Reaching pre-Lehman levels would take us to 11,000 on the Dow and 1,200 on the S&P 500.

Note: This article originally appeared on Fundamental Insights here and here.

Disclosure : No positions