Watch the sectoral indices carefully and compare them with Nifty’s performance.
Sometimes stocks go up, sometimes they go down, and often, they go sideways. Technicians recognise the differences between a trending market (with net gains or losses) and a non-trending market (where prices meander with little net change).
In statistics, the difference shows on regression analysis. The slope of a regression trendline will be close to zero (near-horizontal) in a choppy, range-trading market. The differences also show up in the performance of technical tools used to identify trades.
A trending market responds well to being traded via moving average (MA) systems, for example. In contrast, MA systems give frequent false signals in non-trending markets. A non-trending market responds better to being traded via oscillators like the Relative Strength Index or Stochastic Indicators.
Oscillators are calculated on the assumption that prices will snap back towards a middle point from overbought/ oversold levels. This is what happens in range-trading situations. But oscillators can give misleading signals during trending periods because a market can stay overbought or oversold for months at a time if it’s in a strong trend.
It’s relatively easy to make money during trending phases, more so if you don’t mind being short in order to exploit downturns. During non-trending phases, the chance of losing money and/or over-trading is always higher. In fact, there’s a truism that in bull markets, everybody makes money. In bear markets, only bears make money, and nobody makes money in a range-trading market.
The last is not strictly true. By definition, range trading occurs when demand-supply is temporarily balanced. A long-term investor may use a range-trading phase to build a portfolio without coping with excessively volatile prices. Traders can make money in a range-trading phase if he identifies the phase correctly and picks up successive small up-down moves.
Unfortunately nobody has a reliable method of identifying when a range-trading phase is likely to start or to end. During the phase itself, volumes downshift and daily price volatility eases. Once the range trading period has ended, the breakout point can be identified with some confidence. Apart from prices moving out of the trading range, both volumes and volatility will rise in cases of a genuine breakout.
We’ve just seen an apparent breakout last week. The broad indices lifted to 31-month highs; many stocks hit all-time peaks, and trading volumes rose along with prices. Whatever the preferred systems, most trading signals will be long.
However, current prices are difficult to justify fundamentally. The Nifty is at about 25PE and that is well above the valuations it usually sustains (between PE 14-22). Even as the market surged, we’ve seen advisories and estimates that GDP growth will decelerate from Q1’s 8.8 per cent to 60-100 basis points lower. What is more, Q1 results showed flat or negative earnings growth due to high interest and input costs.
The disconnect is clear: Fundamental deceleration coupled to high valuations and rising prices. However, this divergence doesn’t mean that prices will instantly correct downwards. They may not correct significantly for months to come, maybe not correct at all, if growth accelerates again. There are long phases in bull markets (like mid-2007 to the peak in early 2008) when prices cannot be justified by earnings projections but stocks continue to register gains. A trader cannot short in the middle of a bull market merely because of fundamental disconnects. An investor would also be putting a ceiling on the potential upside if he exited a rising market, until there were clear signals of trend-reversal in the price movement.
However, while staying long in trades and continuing to maintain equity allocations in your long-term portfolio, there are several things that you can do. One is to be mentally prepared for a sudden reversal in the Nifty/ Sensex. Such things are more liable to happen when the fundamentals appear to be out of line. As and when the Nifty corrects, expect it to fall at least 5-10 per cent, and don’t be surprised if it falls 20 per cent.
The second action would be to start watching sector indices and collating /comparing their performances to the Nifty. In this respect, the BSE offers better coverage than the NSE because it tracks a dozen sector-specific indices (the NSE has just four). So long as the majority of sectors are moving up alongside the Nifty, the bulls will be okay. If there’s a divergence where the Nifty continues moving up, and the majority of sector indices go down, you’ll know a correction is imminent. What is more, you’ll know which sectors are over-extended
