China’s stock markets in Shanghai, Shenzhen and Beijing have some unique characteristics and this makes them more challenging to trade.As direct trading becomes more readily available to foreigners, it is important to understand these differences.
China’s small investors have a huge influence on stock prices. Unlike in the US, where large institutions dominate trading, China’s stock market is driven by its 219 million individual investors. They accounted for around 60% of trading volumes in the country last year, according to official estimates. This is often unfavourably compared with trading activity in the US where less than one-fifth of volume is attributed to small investors.
Critics use this difference to claim that China markets are immature and somehow not quite right. I’m not sure that a market dominated by institutional, fund and ETF trading fully represents the price-discovery objectives which are supposed to underpin free market activity. However, markets dominated by these groups do behave differently and call for different trading and investment approaches.
The high proportion of retail traders in China is not responsible for the unique behaviours of the China market. As in any market, there are structural factors at play that shape trading activity. In the US, one of these is after-market trading that distorts the next day’s public opening price of a stock. In Singapore, like China, the lunchtime break loved by long-lunch brokers interrupts the full free flow of the market and has an impact on trading methods.
There are three important structural differences in the China stock market and they impact both retail and institutional trading activity.
The first is the prohibition on intra-day trading. Traders cannot buy this morning and sell again in the afternoon. They must wait until the next day before they can sell. This makes trade risk management more difficult. The result is that there is an increase in trading volume towards the end of the day. Buying near to the close reduces the risk of an adverse price movement hitting stop-loss points. If stops are hit, then the trade can be closed when the market opens on the next day.
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The second prohibition is on short trading. Foreign funds will trade short amongst themselves, but there is no shorting available directly on China exchanges. This means there are no derivative instruments that allow for shorting, so there is no ability to develop effective hedging strategies. This increases volatility in the market because there is no counterbalance trade that can dampen volatility.
Volatility is further exacerbated by the 10% rule which locks trading when prices move by more than 10%. This frustrates demand, so when trading resumes the next day, the pent-up demand magnifies the price move. In a falling market, this leads to a cascade effect where prices drop more quickly than necessary as people rush for the exits. The reverse is true in a rising market as buyers rush to grab stock before it is locked limit-up. Originally designed to dampen volatility, this regulation has the perverse opposite of increasing volatility.
High levels of retail participation in the China market gives individuals a chance to enjoy the fruits of the market rather than rewarding a handful of obscenely overpaid fund managers.
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Technical outlook for the Shanghai market
The Shanghai index achieved two significant events in the past week. First, the index rallied rapidly above the downtrend line. The rally reached the targets calculated using the width of the horizontal trading bands.
Second, the rally reached the targets calculated from the double-bottom pattern. As noted last week, this is not a true double bottom as it did not develop near the lows of the previous uptrend. It is more correctly identified as a retest of support near 3,140. This retest has some of the characteristics of a double bottom in that the pattern can be used to set an upside target. This is more correctly a “W” pattern. The important point is that the pattern projection target was also achieved by the rally breakout.
The rally was triggered by several political announcements. There is a direct relationship between economic policy announcements and the behaviour of the index. It is no different in Western markets where announcements from the Federal Reserve impact equity markets. In China, the reaction is often more explosive, with larger moves such as what we saw last week.
However, as in Western markets, the degree of reaction is usually constrained by the technical features seen on the chart. The Shanghai Index rose to its technical targets and then paused. It is this technical and chart analysis that can be used to answer the question: “Where to go from here?”
The index will consolidate around support near 3,280. A move above this consolidation level has an initial target near 3,350. This target is calculated by taking the width of the trading band and projecting it upwards. It is a reliable method for calculating targets in Shanghai Index behaviour.
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However, the target calculation does not assist in defining how the target will be achieved. It may be another fast rally, or it may be achieved as part of a slow-moving uptrend as we saw in March and April. It is too early to know how this trend will develop, although it is highly unlikely that it will be another rapid rally.
The key feature is how consolidation develops around 3,280. This may include several days or more of sideways movement around this level before a new rally develops. This consolidation pattern will form a second anchor point for the tentative placement of an uptrend line.
Daryl Guppy is an international financial technical analysis expert. He has provided weekly Shanghai Index analysis for mainland Chinese media for two decades. Guppy appears regularly on CNBC Asia and is known as “The Chart Man”. He is a former national board member of the Australia China Business Council
