Chinese Market, Gold, and More About the Right Side of the Trade

Last week we posted some possible break out/break down scenarios in equity markets.  The US markets are holding up well, though we still anticipate them moving down in this correction.  Targets remain the same.  The Chinese Shanghai Composite did not fare so well, however.

As a recap, this was the picture last week:

A close up of the recent breakdown:

We're watching that red support line closely.  If the market breaks below that level, it could spell trouble for other equity and commodity markets.  However, we're not so sure it's going to happen.  To explain why will take a little time...

Earlier today, we discussed staying on the right side of the trade.  That is, is the intermediate term trend intact, or is there a large risk in the intermediate term?  We have a proprietary indicator called the WPA that we use for this.  For the record, it has called every significant top in the US equity markets having been backtested as far back as 1896 and in many global equity markets except one: it called the 1987 stock market crash too late.  That particular event was unique in that it was orchestrated by (then) new electronic trading run amok.

For most market tops, it sends a warning signal roughly six months in advance and a definitive sell signal just after the top, but before more than a few percentage points below the top.  That is, this is the indicator that protects you from the big crash with a warning and several follow-on signals up until its absolutely time to get out.

We noticed that in most emerging markets for which we have data, the signals come a bit later than we'd like.  Those markets are volatile.  However, it still does a good job.  Here's a glimpse using a 10 year view of the Shanghai Composite...

It can be difficult to follow if you're not sure what it is, but after some examination, reading it is quite simple.  In short, the purple wave shows critical levels.  If it breaks down below the zero line (right hand side scale), you absolutely *must* sell.  Once it bottoms and turns up, crossing zero to the upside, you should buy.  Note that fell and has quickly started turning up again--even with this large move down yesterday.  The implication, we believe, is that we will soon see a bottom.

Let's apply the same indicator to the last 10 years of the S&P and see how it did...

A simplified discussion of how the indicator works is on the chart.  In a nutshell, you're looking for a pattern of lower highs/lows when the indicator itself is in a high range.  Those are the warning signs that you have 4-7 months before a possible top.  With rare exception do you have periods where you do not get a lower high before the indicator falls below zero.  Note that this chart covers 20 years, and in that period of time you had 9 sell signals.  The worst performance for the indicator was during the 1987 crash.  Aside from that, the indicator would have at least spared investors from losses.   In two cases, it would have spared investors from the 2000 and 2007 crashes.  There was never a downside to selling when the indicator flashed a sell signal.  In 1987, it was realistically too late to have avoided the main crash. 

Also note that it produced 8 buy signals.  One was a false positive, but could have been avoided if buying only occurs once the price of the underlying security was above a long term moving average.  Filtering those results using that criterion, you have an excellent bottom caller with no losses.

Also note that we have recently seen a peak in the indicator and the beginning of a major decline.  We're still far from the zero line where we'll sell, but we have what may be the first sign of a market top within the next 4-7 months.  At this stage we're looking for a higher low in the indicator, along with a higher high in the equity markets.  That will be the negative divergence we're waiting for and the second sign we're nearing a top.

Perhaps one day we'll publish the complete study to those on our mailing list.  But for now, this should help put the idea of "the right side of the trade" into perspective.


Finally, gold and currencies are tracking almost exactly as predicted last week.  We should know if we're going to get a short term bottom to gold and the euro this week.  The euro is going to need to bottom here or face a bigger sell-off.  Of course, we'll post as the situation develops.