Chart of the week: an engulfing bear emerges

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Australia’s dependence on Chinese raw materials imports is undeniable; they are like our ‘turbo charger’. The saying, “If Wall Street sneezes, we catch a cold” still applies, but I would add that “If China slows, we virtually stop” might also apply. So, the emergence of an ‘engulfing bear’ pattern in the Shanghai Stock Exchange Composite index (SSEC) has implications for us.

The Shanghai Composite is an index of all stocks (A shares and B shares) that are traded on the Shanghai Stock Exchange, which is the fifth largest in the world at US$2,357 billion. Australia by comparison is number nine at US$1,198 billion. According to the International Monetary Fund (IMF), China has the world’s second largest GDP at US$5,878,257 million, after the USA’s at US$14,526,550 million. Australia comes in at number 13 with US$1,237,363 million.

An engulfing bear heralds caution. For an explanation of the pattern, please watch my interview on Switzer, Thursday 22 March 2012. After you have reviewed that interview, return to this report. Here is an update of the SSEC chart presented in that interview:

Shanghai Stock Exchange Composite index (SSEC)

EB = engulfing bear on 14 March, with the index fall ‘engulfing’ the previous 14 days of trade.

In my first two contributions, I chose ‘steady as she goes’ stocks in Spark Infrastructure (SKI) at $1.365 and Envestra Ltd (ENV) at 80 cents less a 2.9-cent dividend = 77.1 cents.

As of last Friday’s close, Spark Infrastructure closed at $1.415, which is up 3.6%, while Envestra closed at 76.5 cents, down less than 1% (ex dividend). As I said, “Steady as she goes.”

What the chart tells me

From a warning perspective, it ticks pretty much all the boxes:

1) It is rare that you have an ‘engulfing bear’ that engulfs 14 days.

2) There was a clear uptrend: The market had gone up 16% already in a little over a month and a half from 6 January 2012 to a peak on 27 February 2012.

3) The trend was waning: The market was treading water for 14 days, and was looking for a reason to either keep going up, or come off.

4) The excuse for a sell-off is provided: Big fundamental news broke on 14 March when Premier Wen Jiabao indicated the property market was still too high and measures to dampen prices would remain in place longer.

5) The 200-day moving average (the yellow line) is almost touched, but clearly rejected.

6) The momentum remains negative, with target support levels at 2,320 (-1.3%) and 2,262 (-4%). It has fallen 1% on Friday since my interview.

7) This index has been a good forward indicator as to where we are likely to head. In November and December, when the West was looking positive into a Christmas Rally, Shanghai was still tanking and saw its low reached on 6 January 2012. How Shanghai trades into these support levels will indicate how much pullback we’re going to get.

What could surprise

1) The index has been in decline for 16 months, starting 11 November 2010. If the above levels of support don’t hold, then hold onto your hats, you may well get a Shanghai Negative Surprise.

2) The 200-day moving average is not really bending up; this downward momentum needs to be broken.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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