Technical Analysis & Charts: Long Term Bonds (TLT) & Shanghai Index (China) ~ market folly

Monday, April 27, 2009

Technical Analysis & Charts: Long Term Bonds (TLT) & Shanghai Index (China)

If you're unfamiliar with technical analysis or just want to learn a little bit about it, here's a recommended reading list to get you started (technical analysis edition). In that post, we've identified some of the best books out there on charts and how to analyze price patterns. Also, for beginners, we recently posted up a free technical analysis tool that will do all the hard work for you and will tell you what the technicals are saying about any stock or commodity in this crazy current market. So, that way, you don't even need to know or understand technical analysis to see what the market action is telling us. Lastly, we've also posted up investor psychology illustrated, which shows how investors react during various periods in the market on a chart basis.

And, before a technicals versus fundamentals debate breaks out, we'd just like to state that we actively use and support both methodologies. We've found that a hybrid approach of fundamentals and technicals encompasses all schools of thought and truly shows the entire picture surrounding a stock/index. The fundamentals will tell you the "why" and the technicals will tell you the "how" and "when." Use the fundamentals to find the good stories and then use the technicals to identify when to get in and out of the name. While you don't necessarily have to believe in or use both, we'd say that it's highly beneficial to at least know what each methodology is saying.

Long Term Bonds/Treasuries (TLT)

So, with the necessary introductions out of the way, let's check out a few charts. Kevin has discovering some great patterns lately, and let's first look at the long term bond (treasuries) chart (TLT).

(click to enlarge)

As you'll see, there have been two distinct trading ranges in TLT over the past few months. Kevin argues that these consolidations often break out to the upside, as evidenced from the first trading range from September to December. TLT consolidated before breaking out to the upside. And, a similar multi-month consolidation has been occurring in the name. With the 200 day moving average acting as support, you could very well see a similar scenario play out. Last September, TLT hovered around that moving average and consolidated around support. This time around, however, things are much more dangerously close to breaking down. If TLT breaks through that 200 day moving average, things could get ugly.

We also want to touch on the correlation between the long term bond (treasuries) chart of TLT and the stock market in general (SPY). TLT and SPY have a loosely inverse relationship due to the 'flight to safety' status TLT has as an investment vehicle. When investors seek refuge from risk, they flock to vehicles like TLT. So, that massive breakout you see on the TLT chart in November/December coincides with the massive drop we saw in equity markets. When SPY tanks, TLT cranks up.

So, if you were to apply this relationship to the current TLT chart, this could be quite worrisome. If TLT does indeed breakout to the upside after a long period of correlation, that could very well mean that a new leg down is coming in equity markets. However, should this consolidation breakdown below the moving average and support levels, then equities could see a further rally. Either way, the consolidation in long term bonds (treasuries) tells us that a big move is coming. The question is, in which direction? While we don't yet know the answer, the charts will tell all and it will eventually reveal itself. One thing's for certain though: whatever TLT does, the equity markets will do the opposite. So, wait for a breakout in either direction of the trading range box. You can then play TLT long or short depending on the action, while playing SPY in the inverse direction of the action in TLT.

Shanghai Index / China

Secondly, we also wanted to highlight a very interesting pattern that Kevin noticed recently regarding the Shanghai Index. He has pointed out that every two months or so, Shanhai has essentially been topping out and selling off. He's denoted the chart below with this unique pattern.

(click to enlarge)

We also wanted to point out a few other things we're noticing. In coordination with the time-lapse selloff every two months or so, the Shanghai Index is simply selling off when it reaches an overbought condition on the stochastics (the 2nd graph on the bottom). Whenever the stochastics hit a reading of 80 or higher, it's time to put it on your watchlists. Once that 80 barrier is breached back to the downside, the selloff starts.

Kevin has noted that he thinks the index will touch its 50 day moving average in the near term and we'd agree with that for 2 reasons. Firstly, as he's shown, the overbought condition every 2 months or so leads to short-term selloffs and they are confirmed by the stochastics as well. We see the 50 day moving average as a logical target due to the fact that moving averages typically act as support. Lastly, you'll notice that Shanghai has been in a nice uptrend every since November, climbing the stairs slow and steady up to the recent highs in April. This uptrend currently is around the 2300 level, which coincidentally is right in line with the 50 day moving average. As the stochastics turn from overbought territory, look for the Shanghai index to head down to the 50 day moving average where it should find some support there to continue its uptrend.

But, as always with this crazy market, be nimble. The trend is your friend... until it's not. While we'd suspect there to be solid support at that level, crazier things have happened in this market. If it breaks this moving average and uptrend, then shorting would be prudent.

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