In our last posting of the Shanghai Composite Index on September 15, 2015, we applied Edson Gould’s Speed Resistance Line (SRL) in an attempt to see where the support levels are and downside risk. At the time we posted the following chart.
We had asserted that a decline below the ascending 2,867.34 level would likely mean that there would be a good chance of the index falling to 2,294.73 and 1,722.12.
A Short Circuit in the Regulation
Since our September 2015 posting, it appeared that with government intervention, the stock market was on the road to recovery. The institution of rules like no short selling, banning of corporations selling stock and government investment funds being required to buy Chinese stocks and limit down or circuit breakers were thought, by the Chinese government, to be a cure to the market decline. However, such interventions, while well intended, usually treat the symptoms and not the actual problem.
The first obvious failure of the intervention policy has been none other than the circuit breakers as the start of 2016 has not been easy for the Shanghai Composite Index. Already, trading has been suspended in two of four trading days with circuit breakers being triggered at intraday declines of –7%. With half of the trading days halted in the new year, Chinese regulators have decided to suspend the use of circuit breakers until a better plan has been formulated.
The way that the circuit breakers were supposed to work was that they would halt trading for 15 minutes after a –5% decline in the Shanghai Composite Index and suspend trading for the remainder of the day after a decline of –7%. These circuit breakers are modeled after those in place in other markets around the world. For example, in the U.S., stock exchanges are halted when the market falls –7% and –13% and trading is suspended if the market declines –20%.
The failure occurred when Chinese market authorities and regulators created a narrower band of declines in a market that is less liquid than an exchange like the S&P 500. If circuit breakers were to be put in place, they should have been at percentages that are much wider than that of the U.S., like halts at –10% and –20% and suspended trading at –30%.
There is a distinction between what the Chinese authorities are doing with circuit breakers as compared to what the U.S. regulators have in place. The Chinese hope to stop a stock market decline with their narrow band for circuit breakers. It seems that U.S. regulators want an “orderly” decline with their rules. Stopping a massive decline in stocks is not possible while an “orderly” decline is a goal that has can be achieved, as demonstrated from October 2007 to March 2009.
Intervention of any sort is not ideal. However, the perception of having control cannot be avoided by regulators no matter the country. Since intervention is the rule, the best that Chinese regulators can hope for is to set the expectation that they’re only trying to accomplish an “orderly” decline with circuit breakers rather than stop a decline from happening. Also, Chinese regulators should acknowledge that their market is young and illiquid relative to other markets. This means that volatility rules and circuit breakers should reflect this fact. Make the circuit breakers much wider than the most liquid and oldest markets.
Downside Targets
Based on the recent market activity since the December 22, 2015 peak, the support level of 2,867.34 has been broken on the downside. This suggests that the next stop will be 2,867.34 while 2,294.73 is waiting in the wings.
A bounce between 2,867.34 and 2,292.73 should be expected before a continuation of the declining trend. Any reversal to the upside should experience resistance at the ascending 2,867.34 level. Historically, a decline to 1,437.70 is not out of the question.
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