The Dow Report: The China Syndrome

By Tim W Wood CPA, January 21, 2005

The growth seen in China over the last several years has been spectacular to say the least. When these trends begin it is always easy to look back at such growth and extrapolate that trend into the future. Furthermore, the fundamental picture always looks the worst at bottoms and the best at tops. Yes, I know the fundamentals are looking up for China. Unfortunately, the current technical picture of the Hang Seng Index does not support a continued boom for China, at least not until the looming correction has hit bottom. In fact, the current technical picture is warning that there may be a sizable downturn ahead for China in spite of the positive fundamental outlook.

The first chart below is a daily chart of the Hang Seng. I want to point out that the rally out of the December 10, 2004 short term cycle low was a failure in that it failed to rally above its previous short term cycle high. I have marked the failed advance out of that low with a red trend line above these two short term cycle tops. This failure set the current cycle up to decline below its December short term cycle low, which it did. So, from a short-term cyclical perspective, the Hang Seng has broken down. Since January 12, 2005 we have been seeing a small counter trend up swing in the Hang Seng. But the next short term cycle low is not due until later this month or in early February. We see weaker prices into that timeframe before another meaningful counter trend rally develops.

The next chart below is a weekly chart of the Hang Seng. The last intermediate term cycle low occurred on October 25, 2004. This low is the last low to the right marked with an "IT." The new cycle that began from that low advanced into the early December top and has since turned down with the failure of the short term cycle as explained above. The decline into the intermediate term cycle low is still under way. The important level to watch is the October 25, 2004 intermediate term low. I have marked this low with a green line. If that level is violated it will serve to confirm that the longer term cycles have also turned down and this would set the stage for a much deeper sell off into even longer term cycle lows.

Next I want to introduce you to two indicators that I have developed. The first one I want to talk about is my Cycle Turn Indicator. This indicator is plotted in red with price in the chart above. I developed this indicator to help identify intermediate term cycle tops and bottoms or turn points. When this indicator turns up at the intermediate term cycle windows, along with a couple of other technical developments, of which I will spare you the gory details, it marks the cycle low or the upward turn point. When it turns down at expected intermediate term cycle tops, along with a couple of other technical developments, which again I am sparing you the details, it marks the intermediate term cycle top.

I have marked a few of these intermediate term cycle lows for you to see. Notice that in the current case this indicator turned down along with the failure of the shorter term cycle as explained above. Together, this gave a strong indication that the Hang Seng had made a turn of at least intermediate degree. The fact that this indicator has remained negative during the recent rally is telling us that the recent rally is a counter trend move and that the move down into the next intermediate term cycle low is still underway.

The next chart below is also a weekly chart of the Hang Seng. The indicator presented here is my intermediate term Trend Indicator. This indicator is a bit slower to turn, but it is designed that way in that it is meant to be a confirming indicator. Notice that when it turns it generally marks major trend changes. This indicator has now turned down.

I also want to point out that this indicator has created a rather large divergence between the February 2004 price high and the December 2004 price high. What I mean is that the December 2004 price high was made at a higher level than the February 2004 price high. Yet, the Trend Indicator did not confirm the higher December 2004 price high because the indicator made a much lower high. I have found that such divergences at tops are generally bad news for any market in which this occurs.

Notice that at the 2003 price low on the Hang Seng just the opposite occurred. In this case there was a positive divergence spanning over a year and a half period. In October 2002 the Hang Seng made a lower price low than it did in September 2001. Yet, the Trend Indicator made a higher low and thereby did not confirm the lower price low in October 2002. This divergence then built, as the next price low was made in April 2003, at an even lower price low but a higher low on the Trend Indicator. This large scale divergence was warning of a bottom for months before the actual low occurred.

Going back to our current situation, we now have the opposite of what happened at the bottom. The divergence that you see is warning that we very likely have seen an important top in the Hang Seng. Sure, it is possible that this divergence could grow in that we could see another push up in the Hang Seng and another non-confirmation with the Trend Indicator. But, unless these divergences are corrected there is major trouble brewing for the Hang Seng and violation of the October 2004 intermediate term cycle low should mark the beginning of such decline.

The signs of trouble can also be seen on the monthly chart below. I have plotted my Cycle Turn Indicator on this chart. Notice that we now have a down turn on a monthly basis.

So, my technical work is telling me that odds favor a down turn for China and potentially a significant one. I will add that there is a high likelihood that this down turn is about to begin unfolding and should be confirmed with a break below the October 2004 low.

At the outside I would say that the Hang Seng could perhaps hold on for one more intermediate term cycle advance as the divergence builds even more. But, in either case the Hang Seng is setting up for a major fall. These divergences are like pressure that builds up deep within the earth along the fault lines. The more the pressure builds the greater the earthquake that follows. Unless these technical conditions are corrected China is setting up for a financial earthquake. This quake could occur with a small reading on the Richter scale. But, current indications are that we should expect something of greater magnitude that may just rock the entire world.

I believe that China is about to enter Phase II of the great global bear market. If it’s actually true that China has been responsible for so much of the "recovery" since 2002 then imagine what might happen if they do see a down turn. You have been warned!

Over the last couple of weeks I have mentioned that I have greatly expanded my newsletter service to include not only the monthly newsletter, but also web based comments during the week. I also provide charts on the stock market, the dollar, bonds, gold, silver, oil, the HUI and others that include my proprietary Cycle Turn Indicator and Trend Indicators. If you are interested in a service that is a detailed technical based newsletter with a focus on the Dow theory, cycles analysis and the works of master technician George Lindsay, along with web based comments and these indicators, please visit www.cyclesman.com for details and Contact Information.

Tim W. Wood

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Tim W. Wood CPA
Cycles Man
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