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Covid-19 impact may push markets down a new pathway
THE market impact of Covid-19 is not a passing phase. It brings with it a market reset. It doesn't change the credit fundamentals in the same way as the Global Financial Crisis (GFC). This seismic change strikes at the structure of modern economic activity and exposes cracks and weaknesses.
The path to better assessment is barred by one significant market myth. This myth is found in the oft-repeated advice not to panic because the market always goes up in the long term. This is a comfort when your investment portfolio is bleeding money.
It's a myth based on survivor bias. The market always goes up because the losers are dropped from the index calculations and new winners are added. It is called rebalancing and it ensures the index is only ever made up of winning stocks so it always goes up.
There are only two possible market outcomes of the Covid-19 disruption. The market will either resume its uptrend or plumb new lows. It's too early to know which outcome will prevail, but we can establish key behaviour points that quickly point the way to the most likely developing outcome. Recognising these provides a signal to get out or to stay in the recovery.
There is nothing wrong with starting analysis with the obvious. The long-term uptrend in the Dow has been dramatically interrupted. This is different from the correction in December 2018 because the fall is both faster and deeper. It is triggered by an external event which can by managed by government, but not influenced.
For the uptrend to resume, the Dow will need to rebound above the values of the long-term Guppy Multiple Moving Average (GMMA) currently near 28,000. The GMMA provides good understanding of trend strength and stability. True long-term trend continuation calls for the Dow to move above previous highs near 29,500. Anything less is not a resumption of the long-term trend.
The alternative outcome, plumbing new lows, is defined by the future price pattern behaviour of the Dow. The thick lines show how this might develop. This is a classic and reliable end of trend head and shoulder chart pattern. This is what investors are watching.
The pattern starts with a good rebound from the recent blow point. This is not just a few days of rebound and retreat as we have seen this week. It's a clear recovery trend moving toward long-term resistance near 26,600, or higher near 27,600.
This is then followed by a substantial retreat. This creates a peak right-hand shoulder and completes the head and shoulder reversal pattern. Nervous investors use this as an exit signal and go to cash, or gold. Hopeful investors wait for the final confirmation of the close below the previous low near 24,500. By then the capital destruction is substantial.
The completed pattern not only signals an end of trend, but it also provides a method to set a downside target. The distance between the head or peak of the pattern, and the neckline connection the lows - line A - is measured. The value is projected downwards to give a target near 20,000. This suggests a shock in the order of the 2008 GFC.
The unresolved question relates to which market will provide global leadership and hence, which will provide better trade and investment opportunities. While all eyes are on the Dow and market contagion seems to spread from there, it's unwise to ignore the China market behaviour. This behaviour may also provide a template for the Dow recovery, so investors watch closely for similarities.
The Shanghai index gapped down when the market resumed trading after the Chinese New Year holiday break. This dramatic downward drop is similar to the current Dow behaviour, but the resilience in the Shanghai index is remarkable. The rebound developed despite the absence of strong government initiatives.
Instead of Reserve Bank interest rate cuts, the Chinese government uses different levers to manage this economic shock, and these measures were announced after the first week of market recovery. The retreat and rebound behaviour have enabled the placement of an up-trend line based on two anchor points.
Investors wait for a second retreat and rebound to find the third anchor point for the trend line potentially near 2,930.
A rebound from this support feature would move the Shanghai index into the narrow trading band between 2,980 and 3,040 and signal a resumption of the sideways trading that has characteristics the Shanghai index since April 2019.
This is no strong long-term uptrend like the Dow. For traders, the Shanghai index offers stable rally and retreat trading opportunities and the potential to move above long term resistance near 3,040. In a worst-case scenario, this sideways behaviour is preferable to a steady downtrend destruction of investment capital.
With Covid-19, we are travelling down a new pathway. Knowing which signposts to look for, and what they mean, will make the journey safer.
- Daryl Guppy is an international financial technical analysis expert. He appears regularly on CNBC Asia and is known as "The Chart Man". He is an equity and derivatives trader and author of books including Share Trading, Trend Trading and The 36 Strategies Of The Chinese For Financial Traders.