A trend reversal in the stock market seems likely. Bulls should be cautious.
Cyclical theories permeate economic literature because economic conditions repeat the same way that natural conditions do. Unfortunately, as with weather, it is impossible to accurately time economic cycles.
Economic cycles are fractal in nature. Booms and busts occur chaotically, so each cycle is somewhat different from previous ones. Cycles occurs on all scales. Every trading session sees contrasting periods of bullishness and bearishness. So does every year, and every decade.
Trend-following technicians refer to primary, intermediate and momentary (or short-term) trends. These trends can move in different directions. The primary trend is the long-term trend. It depends on the individual technician to define “long-term”.
A day trader for example, may consider a month-long settlement period long-term. The intermediate trend is somewhere between one-fifth (20 per cent) to one-twentieth (5 per cent) the length of the primary trend. The momentary trend may be one-tenth or less, of the intermediate trend.
A standard long-term timeframe is one year, which is often rounded down to 200 working days, or approximately 50 work-weeks by many technicians. Intermediate trends are classified as generally lasting between 3-12 weeks. The short-term trend could be just one day.
Any long-term trend contains many intermediate trends. Some will be in the same direction as the primary long-term trend. An intermediate trend, which moves in tandem with the primary trend, will be longer and larger in magnitude. If the short-term trend also goes in the same direction, the three trends are in phase and the movement is likely to be very powerful.
Intermediate trends in the opposite direction are defined as corrections and they can be quite significant as well. A 10 per cent move against the primary is common and 20 per cent corrections also occur. There is obviously a point at which a correction becomes so large that it turns into a full-scale trend-reversal and alters the direction of the primary trend.
Contrarians looks for corrections and also for full-scale trend reversals. A good strategy during a correction is to act in the direction of the temporarily weaker primary trend. A correction during a bull market is a good time to buy on price declines. A correction in a bear market is a good time to offload depressed stocks, since you get temporarily higher prices.
A full-scale trend reversal requires a different strategy. If you think a full reversal is on, you should act against the primary trend. If it was a bull market, sell in anticipation of a new bear market. If it was a bear market, buy. Unfortunately, identifying trend reversals is not easy. If you judge wrong, you get trapped when the primary trend strengthens again.
One indicator for distinguishing between a reversal and a correction, is the length and magnitude of the preceding primary trend. If there's been a roaring bull market driving values up for years, the next intermediate correction is more likely to be a reversal. If the market's primary trend has been less prolonged or less strong, a full reversal is actually less likely.
The Indian stock market now seems to be heading into an intermediate downtrend after gaining 15 per cent in the past three months. Is this likely to be a reversal or a correction? The market has been up since March 2009, and the Nifty has more than doubled in the last 18 months. On both counts of time and magnitude, a full-scale trend reversal cannot be ruled out.
Other macro-indicators such as the direction of interest rates appear negative. Rates have treaded up since late 2009 and stock market valuations now seem high in comparison to current interest yields. To put that in perspective, the 364-Day T-Bill yield is around 6.25 per cent. A value investor would be uncomfortable buying any stocks above PE 16.
The Nifty's PE is at around 23. A surge in Q2, 2010-11 earnings could offset the high PE. But when we look at Q1 2010-11 results, this appears unlikely. While growth remains good in turnover and operating profits, there has been a slowdown in earnings growth in Q1, probably due to higher interest burdens.
On both technical and fundamental grounds, one would expect a fairly big correction over the next two to three months and it may turn into a trend reversal. A game-changing event that led to vastly increased stock market volumes or a sudden drop in interest rates, etc, could avert a full trend reversal. But in the absence of such a trigger, bulls should probably be very cautious and bears should be looking for opportunities to short on the way down.
