Tuesday, December 14, 2010
The Indian market is undergoing a secondary correction, after which it will be headed much higher
The markets have been correcting over the past few weeks and lot of traders and investors are asking themselves the question whether the bull market is over or if it is just a temporary pause and correction in the overall bull market. The Nifty made an "intermediate top" at 6,339 which was very close to its all-time high of 6,357 touched in January 2008. From there it corrected to 5,690, then bounced back from those levels to 6,080 levels and fell to below 5,800. Today it closed above 5900. What next?
Well, we are working with the assumption that while Nifty has resistance around 6,357 which is its all-time high and the index can fall all the way to 5,350, a new journey for the market has begun a few months ago which will take it to much higher levels over the next few years-a target of 30,000 to 50,000 on the Sensex over the next three to seven years is imaginable and achievable. The market has chosen to correct first before the upmove after hitting 6,330 in early November. This is a "secondary correction of the primary bull market" which generally takes off anywhere between 33% and 66% of the previous primary upmove.
The Nifty has formed certain bearish formations like "three black crows", of which first is a "bearish engulfing pattern" and "dark cloud cover" on the weekly charts, "evening star" on the long term monthly charts, in the process of forming a "high wave candle" on the long-term quarterly charts, "black turnaround line" on the weekly three-line break charts, conversion from yang (thick bullish) to yin (thin bearish) line on the weekly 4% kagi charts, breakdown of price oscillators (RSI, ROC, MACD, KST, DI, Stochastics), fall of the 50-day MA, and so on.
The secondary correction will have a first target of 5,650 on the Nifty (18,800 on Sensex) which is a reasonable support (falling window). That is the level when the Sensex had hit the lower circuit in January 2008 and which was the beginning of the previous bear market. Without going into detail, looking at the chart patterns, candle sticks, neo-classical wave, time series analysis, retracements, trendlines, MAs, oscillators, etc, if the 5,650 level does not hold then the next support is at 5,350 and the final support-as it could go down further-is 5,050 (17,200). If for whatever reason the level of 5,050 is not held on the Nifty, which I personally don't believe will happen, then we have to question the validity of our assumption of it being a "secondary correction" of the primary bear market. At every major support level, that is 5,650, 5,350 and finally 5,050 we have to look at "bottom formation" patterns on the charts. However, once this secondary correction is over, the primary bull market will resume, which will have a first target of 7,000 (23,500) over the next medium-term.
The breadth has been very negative last week and lots of mid- and small-cap stocks have been butchered. The BSE Mid-cap index was trading at around 7,260, a level when the Sensex was at 15,600. It has major support around 6,300. Similarly, the BSE Small-cap was trading at 8,745 last week, which corresponds to the Sensex trading at 15,400. The BSE Small-cap index has major support around 8,000. The only positive thing in all the recent carnage is that the mid- and small-caps have corrected too sharp and fast, which is what happens during "secondary corrections" of primary bull markets. Now, the large-caps might correct somewhat over the next few days/weeks and then an "intermediate bottom" might be formed in the Nifty at close to the levels stated above.
To understand the current price movements more clearly, let us look at the 20-year chart of the Sensex. The Sensex was at around 690 in February 1990, from where a bull market began and it topped out at 4,650 in March 1992 (when the Harshad Mehta securities scam broke). Then it touched a bottom at 2,000 in March 1993 which was a bear market bottom. However, this was not the commencement of a new bull market. It then made another top at 4,615 in August 1994 and a cyclical bottom at 2,700 in December 1996. The real bear market bottom was made in October 1998 at 2,785. The new bull market which began there, took the Sensex to 6,175 in February 2000 where it topped out with the 'technology bubble'.
The Sensex crashed to 2,600 by September 2001 which was a cyclical bottom. The real bear market bottom was then made in August 2003 at nearly 2,900 from where the new bull market took it to 21,206 in January 2008. Kindly note, the four corrections in the interim, that is April 2004 (the Congress party victory in the Lok Sabha polls and formation of government with the support of the Left), October 2005 (small-caps bubble), April 2006 (mid-caps correction), and August 2007 (first news of sub-prime) were all secondary corrections within the primary bull market.
After making the bull market top in January 2008, it entered a corrective phase and made a cyclical bottom at 7,697 in October 2008 and the real bear market bottom at 8,050 in March 2009. From there on the new bull market commenced which made an intermediate top at 21,108 in November 2010. Currently, we are going through a secondary bull market correction which is likely to make a bottom somewhere between 18,800 and 17,200. And once the secondary correction bottom is in place, we will have a first target of 23,500 and then the longer-term target of anywhere between 30,000 and 50,000 over the next three to seven years.
Fundamentally, most of the factors remain long-term positive with the P/E at 15.2x FY2012 estimated earnings, which is at 9% premium to the long-term 10-year average, but below the peak bubble P/E of around 25x in January 2000 or January 2008. P/BV is 2.8x FY2012E which is at 15% premium to the long-term 10-year average, but ROE at 17.8% is lower than LTA of 18.7%. Market cap/GDP at 1.1x is not cheap, but below the peak of 1.8x in January 2008 and the earnings yield of the Sensex is 6.6% compared to an 8.1% bond yield (10-year GSec) and the earnings yield/bond yield is 0.81x as compared to the long-term 15-year average of 0.88x.
However, the major negative remains the high short-term interest rates. The yield curve from being steep a few months back has now in fact become inverted. Having said this, the positive factor is that the long-term (10-year GSec) yields have been in the range of 7.5% to 8.1% when short-term rates increased by almost 600 bps from 3% to 9% over the past few months. Hence, the short-term interest rates have risen too much, too fast. These kinds of rates are certainly not sustainable and they would come down. The peaking of interest rates might correspond with the end of the "secondary correction" in equities. Each asset class performs differently during different phases of the economic cycle. The general rule for different stages of an economic cycle and the preferred asset class during each stage is described below.
- Interest rates peak and bond prices bottom out-preferred asset class GSecs.
- Demand for credit declines-preferred asset class GSecs.
- Central bank increases money supply-preferred asset class GSecs and corporate bonds.
- Equities bottom out-preferred asset class equities.
- Commodities bottom out-preferred asset class cyclical and commodity stocks/commodities.
Currently, we are in the stage where over the next few weeks/months interest rates are likely to peak out, bond prices should bottom out, demand for credit might decline at higher interest rates, The central bank will increase money supply and liquidity, which it is already doing daily through repos, and equities will bottom out. (That is, the secondary correction in equities which we are seeing currently will end.)
To conclude, a good strategy might be to shift funds from short-term money market instruments to long-term gilts/bonds or lock into long-term rates and keep funds ready to buy in the "secondary equity market correction" so as to benefit when the interest rates peak out and start coming down and equities resume their primary uptrend.
(Mehrab Irani is general manager, investments, with Tata Investment Corporation Limited. He has over a decade of experience in investment research, portfolio management and investment banking. The views expressed in the article are his own.)