Should you invest in large-cap or mid-cap stocks?

The stock market has been in a down trend for more than a year – losing 25% from its Nov ‘10 peak. Experts suggest that such falls provide excellent opportunities to accumulate strong large-cap stocks. Large-cap stocks are less risky and offer steady rather than spectacular returns.

Most small investors have a penchant for seeking out small and mid-cap stocks in the hope of making multi-bagger returns. But high returns are usually accompanied by high risks. What should small investors do? How to contain risk without missing out on returns?

In this month’s guest post, Nishit looks at the pros and cons, and comes up with an alternative approach.

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The argument will always continue whether to invest in large-cap or mid-cap stocks. One of my friends was asking me this morning whether it would be a good idea to invest in mid-cap IT stocks. It was the trigger for this post.

Mid-caps have several advantages. They are the real multi-baggers. Microsoft and Infosys were mid-caps once upon a time. Mid-caps can be a 10-bagger or even a 100-bagger. Mid-cap stocks carry a greater amount of risk as compared to large-cap stocks. In a bear market, a large-cap may lose 50% of its value whereas a mid-cap can lose as much as 90-95% of its value.

So, how does one address this conundrum? Every portfolio needs to be garnished by a sprinkling of mid-cap stocks, just like our food needs a sprinkling of salt to add to the taste. Just as too salty food is not good for health or taste, too many mid-caps is not good for the health of your portfolio, which leans towards risk.

How does one identify good mid-cap stocks? There are several criteria one must keep in mind.

1. They should have sound business models.
2. They should be generating real profits.
3. They should have good management. This is a very tricky question. How does one see a management to be good? A small investor cannot go and meet the management of a company he likes. One must look through the annual reports and notifications of the stock exchanges. The promoters should not have a shady reputation, or indulge in activities that harm shareholders – such as pledging of shares or dazzling announcements aimed at TV and newspapers.
4. The companies should be generating positive cash flows and providing steady dividends. Steady dividends can be ignored if the business is growing and the promoters are not investing the money in unrelated activities.

Now that we have looked at what criteria to use in selecting a good mid-cap company, the next question is when to invest. In bear markets, mid-caps are battered beyond recognition. Hence, one can follow this strategy. Keep accumulating large-cap stocks on every dip.

For mid-caps, buy only if the Nifty sustains above its 200 day Moving Average for a week or more. 200 day Moving Average is considered the dividing line between bear and bull markets.

Also, depending on one’s risk profile, the allocation has to be done between large-cap and mid-cap ideas. A conservative portfolio can have a 80:20 ratio between large and mid-caps. A more aggressive portfolio can have 60:40 ratio between large and mid-caps.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

Gold and Silver Chart Patterns: an update

Gold Chart Pattern

Two weeks back, gold’s price was making a second attempt at a pullback towards its 200 day SMA from below. It was expected that the bears would resort to selling and push the price down once more. But after a bit of a struggle, the price crossed above the still-rising 200 day SMA and has stayed above it since then.

Technically, the support at 1550 was not broken – gold’s price only had a day’s close below the support level. So, the drop from 1900 to 1550 should be treated as a bull market correction. The 30 day and 60 day SMAs (not shown in chart) did not fall below the 200 day SMA. Once the 14 day SMA crosses above the long-term moving average, the bulls will regain control.

Gold’s chart appears to be forming a bullish ‘falling wedge’ pattern, which is a ‘continuation’ pattern from which the likely break out should be upwards. Please remember that technical analysis is not a science, and patterns don’t always play out as expected. Buy on a convincing rise above 1700.

Silver Chart Pattern

Despite a smart pullback above the 14 day SMA, silver’s price is trading below its 30 day and 60 day SMAs (not shown in chart) and well below the 200 day SMA – the hallmark of a bear market.

The white metal is falling within a downward-sloping channel, making a bearish pattern of lower tops and lower bottoms. The 200 day SMA is forming a ‘rounding top’ pattern, hinting at a further fall in silver’s price.

Why did the stock market fall despite a good IIP number?

India’s Nov 2011 IIP (Index of Industrial Production) came in at 5.9% – higher than the consensus estimate – raising hopes of a quick return to the growth path. Considering the Oct 2011 IIP of –5.1%, there was a huge 11% swing month-on-month.

The stock market should have celebrated by spiking higher – specially since both the Sensex and Nifty are in the midst of rallies from their recent bottoms. Instead of doing the obvious by rising, both indices lost ground. Not much, but enough to cause consternation among small investors.

What is going on? Is this just the way Mr Market behaves to separate investors from their hard-earned money?

There can be a few logical explanations, which are mentioned below:

1. Both the Sensex and Nifty are in the midst of prolonged bear markets. Good news tend to get ‘discounted’ quickly and bad news causes renewed selling during bear markets.

2. Infosys – which is generally considered to be one of the bellwethers of the Indian stock market – announced better than expected Q3 results, but disappointing Q4 guidance and got hammered. Its high weightage in both indices caused the fall.

3. Oct 2011 IIP number was unusually low – but one must remember that it was a festival month (Navratri and Diwali), which meant lower production days due to the holidays. Nov 2011 IIP was comparatively much better, but some of the new orders may be due to inventory replenishment. Lower growth usually leads to inventory draw-downs (companies tend to let their existing inventory get depleted almost completely before placing new orders).

4. Technically, both indices retreated after facing twin resistances from their 50 day EMAs and DTLs (refer last Sunday’s post on Sensex and Nifty chart patterns).

5. All of the above.

Stock markets don’t necessarily move according to logic. In the short-term, sentiments can, and often do, overrule the fundamentals. So can a rush of buying or selling by the FIIs. What should small investors do?

Remember an old saying: “Buy the rumour; sell on news.” There is no better example of that maxim than today’s price action in the TTK Prestige counter. The company announced impressive Q3 results, but the stock lost more than 7% after the ‘good news’!

The stock market is in a state of flux. After 14 months of down trend, small investors are becoming impatient to buy in the hope of a trend reversal soon. Please be aware that interest rate is still high. So is inflation – though food inflation has turned negative. Stock markets don’t reverse trend till the first few interest rate cuts happen.

There is a clamour for a CRR rate cut from all corners. If the Nov 2011 IIP figure is the reality, i.e. economic growth is back on track instead of what has been mentioned in point 3 above, then there is no reason for the RBI to cut the CRR – let alone cut the interest rate. A rate cut may stoke the inflation fire.

In other words, there is no need to turn bullish yet. Await Q3 results of the big guns and RBI’s policy announcement on Jan 24. You may miss the absolute bottom by being conservative, but in a bear market it is better to be safe than sorry.

5 strategies to follow in a bear market

Most small investors enter the stock market when a bull market is nearing its peak. They don’t have clear goals and strategies, and get caught on the wrong foot by the bear market that inevitably follows. The trauma of losing money in a hurry can be soul-destroying.

Without the necessary skills and experience of surviving in a bear market, investors resort to all kinds of ill-advised strategies in an effort to quickly recover the losses. That only makes a bad situation worse.

The current bear phases in the Sensex and Nifty indices are 14 months old, and so far there has been very little indication of a reversal in the down trends. Experts are saying that the bear phase can last till the first half of Financial Year 2012-13. If they are right, the bear market may sustain till Sep 2012 – another 9 months!

Whether you are one of the unfortunates who are ‘stuck’ at higher levels, or a more seasoned investor who is sitting on cash to deploy at lower levels, here are 5 strategies that you may want to follow in the current bear market:-

1. Remember that bear market rallies are sharp and swift. Don’t jump in by thinking that you will miss a buying opportunity at a low entry price. Such rallies are some times ‘created’ by bears so that they can sell at a higher price.

2. Just because a stock has fallen to a 52 week low doesn’t mean it can’t fall any lower. As long as the trend is down, it can fall lower. If it is worth buying, being patient can help you to enter at a much lower price.

3. A sharp vertical drop in price – often accompanied by strong volumes - usually attracts a lot of buyers who believe that they are being smart by entering at a low price. It is the sign of a ‘panic bottom’, which seldom holds. Prices bounce up on the buying, but then fall lower than the ‘panic bottom’.

4. At the risk of sounding like a broken record (or, a damaged CD) – do not, repeat do not, average down in price. No one knows how much further a stock’s price will fall, or worse still, if it will ever recover (e.g. Cranes Software). It is far better to average up once the price forms a bottom and starts its up move.

5. Major down trends are not reversed in a day or a week. Bottom reversal patterns take a few weeks to a few months to form. Ability to ‘read’ chart patterns can help investors to accumulate a stock while a reversal pattern is ongoing (refer Chapter 7: Reversal Patterns of my free eBook: Technical Analysis – an Introduction).

If you can’t ‘read’ a reversal pattern, don’t worry. Eventually, prices will turn up and a new bull market will begin. You may enter at a higher price, but the chances of a loss can be minimised by using a trailing stop-loss.

Related Posts

Five things you should avoid in a bear market

Five more things to avoid in a Bear Market

Gold and Silver Chart Patterns: pullback rallies

Gold Chart Pattern

Two weeks ago, the following comment was made about gold’s price chart: “A pullback to the long-term moving average was only to be expected, and has been in progress for the past three trading sessions.” Some times, price charts provide an ego boost to technical analysts by behaving exactly as per expectations. The pullback reached the still-rising 200 day SMA, only to encounter selling pressure and plummet to a close below the 1550 level.

The break down below the symmetrical triangle pattern and the pullback to the 200 day SMA were both selling opportunities. At the time of writing this post, another pullback attempt is in progress to prevent a bear market – but it may meet the same fate as the previous one. The 14 day SMA is about to drop below the 200 day SMA. A close below 1520 will confirm a bear market.

Technically, the support at 1550 hasn’t been convincingly breached yet because gold’s price jumped up after a single day’s close below 1550. There is stronger support between 1450 and 1480, if 1550 does get breached eventually. Can gold’s price fall even lower? Anything is possible once the bears get the upper hand – and the technical signals are looking ominous for bulls.

Silver Chart Pattern

There are no doubts about bear domination of silver’s chart pattern. The white metal dropped to a new closing low of 26 for a day before embarking on a sharp pullback. The 14 day SMA (as well as the 30 day and 60 day SMAs – not shown in the chart) is falling below the 200 day SMA and silver’s price is trading below both SMAs – the sign of a bear market.

Stay away till trend-reversal signals become visible.

Gold and Silver Chart Patterns: an update

Gold Chart Pattern

In a post two weeks back, the possibility of a break below the symmetrical triangle pattern on gold’s price chart had been mentioned, even though gold was trading way above its rising 200 day SMA. A downward target of 1450 was also mentioned. Such huge drops – from 1750 to 1450 - don’t happen in one shot. But the drop of 150 within two weeks must have shaken the confidence of die-hard gold bulls.

A swift and steep drop below the 200 day SMA stopped just short of the support level of 1550 (where multiple tops were formed in May and Jun ‘11). A pullback to the long-term moving average was only to be expected, and has been in progress for the past three trading sessions.

The 14 day SMA is falling towards, and may soon drop below, the 200 day SMA. That will be the first warning of a likely change of the bull trend. The 30 day and the 60 day SMAs – not shown in chart above – are also falling. Note that the ‘panic bottom’ of 1600 – formed in Sep ‘11 – has been broken. Panic bottoms seldom hold.

The break down below the triangle was a selling opportunity. So is the current pullback. Long-term holders who may have entered at lower levels can stay invested with a stop-loss at 1550.

Silver Chart Pattern

The 200 day SMA has just about started to fall as silver’s price is moving down towards the lower edge of its downward channel. All the three moving averages – 14 day (in chart above), 30 day and 60 day SMAs – have crossed below the 200 day SMA, with silver’s price trading below all four.

Silver is in a bear market, and can fall to much lower levels. Looks like ‘game over’ for the bulls.

Gold and Silver Chart Patterns: an update

A few months of correction, and all the chatter about a return to the gold standard and the dollar no longer being a reserve currency is off the table! The signs of revival seen on the chart patterns of gold and silver two weeks back proved to be illusory.

Both precious metals are now trading below their 14 day, 30 day and 60 day SMAs, and may drop down to test their Sep ‘11 lows. Will that provide a buying opportunity?

Gold Chart Pattern

The answer should be ‘Yes’ for gold, because it is trading well above a rising 200 day SMA and is in a bull market. Note that the 1750 level provided good support till gold’s price chart formed a small ‘double-top’ reversal pattern and suddenly dived on Thu. Nov 17 ‘11.

A test of the 1600 support level is on the cards. The support should hold since the 200 day EMA is also near 1600. Just in case 1600 gets broken – nothing is certain in technical analysis – 1530 should be a stronger support due to the multiple tops formed near that level during Apr – Jun ‘11.

The downside to a bounce up from 1600 is that a bearish ‘descending triangle’ will get formed, from which gold’s price may fall all the way to 1300. This is a hypothetical possibility as of now, so no need to be alarmed. Let the chart pattern unfold. But it may be prudent not to be gung-ho bullish about buying the likely bounce up from 1600.

Silver Chart Pattern

The answer to the question is ‘Not yet’ for silver, because the white metal and all three of its moving averages (only the 14 day SMA is shown on the chart) are trading below the 200 day SMA – which indicates a bear market. The Sep ‘11 low of 28 may be tested and broken.

Note that silver’s price was consolidating within a small symmetrical triangle formed near the support level of 34, before breaking down sharply on Thu. Nov 17 ‘11. Drawing lines through tops formed in Apr ‘11 and Aug ‘11, and bottoms formed in May ‘11 and Sep ‘11 will form a broad downward-sloping channel pattern with its lower end currently at 26. That is a level which provided support in Nov ‘10 and Jan ‘11 – so an upward bounce can be expected from 26.

Bravehearts may try to bottom-fish at 26. Conservative investors should buy only on a convincing break out above the downward-sloping channel.

Gold and Silver Chart Patterns: end of long bull rallies?

Gold Chart Pattern

In an update to gold’s chart pattern two weeks ago, the following conclusion was drawn:

‘The present correction/consolidation – whatever it may turn out to be – should restore the technical health of gold’s chart for the next up move.’

The expected drop to 1600 from the double-top at 1900 happened quickly, and gold’s price has been consolidating in a narrow range of $50 since then. It is beginning to look like the next up move may take a while, and gold’s price may dip further – possibly to the 200 day SMA (at about 1520) - before a sustained rise can begin again.

Note that the 200 day SMA is still rising, with gold’s price trading above the long-term moving average. Technically, gold is still in a bull market. But extreme caution is advised about entering at this stage – since the yellow metal is trading below its 14 day, 30 day and 60 day SMAs. All three are likely to act as resistances on any up moves. Not to forget the valley level of 1750 (between the two tops at 1900), which should provide strong resistance to a price rally.

A fall below the 200 day SMA will also mean a 20% drop from its peak, and a likely trend reversal from bull to bear. If you are still holding and in profit, maintain a strict stop-loss at 1520.

Silver Chart Pattern

There are no doubts about the state of silver’s price chart pattern – it is in a bear market. It has dropped more than 20% from its peak and is trading below the 200 day SMA. The 14 day SMA has slipped below the long-term moving average. The 30 day and the 60 day SMAs have turned down and may cross below the 200 day SMA in the near future.

Why is silver faring worse than gold? The answer probably lies in the fact that silver is not something you just buy and lock up in a bank vault. It has several industrial uses as well. With global manufacturing in clear de-growth, industrial demand for silver is declining. (The fall in copper prices are also due to this same reason.)

If you are still holding, use any price rise to exit. On the down side, the next supports are at 24 and 20.

To make money in the stock market, avoid these three buying mistakes

Stock markets have trading days or holidays. Using stock market jargon, trading days can be either ‘bullish’ or ‘bearish’. But if you follow the so-called experts on business channels or the pink papers, stock markets have ‘good’ days or ‘bad’ days. On ‘good’ days, the Sensex gains. On ‘bad’ days, the Nifty falls.

What happens when both the Nifty and the Sensex drop by 4% – like they did today? It is a ‘terrible’ day! For whom? Obviously for the brokers and the business channels, because their business thrives on ‘good’ days. When the market moves up, more viewers tune in, and more investors place ‘buy’ orders. For investors, who were lucky or prudent to sell at higher levels, ‘panic’ days offer a great opportunity to cover back the stocks sold earlier.

So, are ‘panic’ days great opportunities to buy? The short answer is: No. In an earlier post, ‘How to tackle a ‘panic bottom’, I had explained that panic bottoms seldom hold. Technically, today’s heavy FII selling didn’t create a bottom in the Sensex or the Nifty. But it is a sign that the lower level of the last six weeks’ trading range may get tested, and possibly broken.

If you ever watch a tennis match between a top 10 player and a player ranked much lower, you will notice that there may not be much difference in their respective skill levels. The big difference lies in their ‘unforced errors’ stats. The better player makes fewer ‘unforced errors’.

In stock market investments, there are three such ‘unforced errors’ that you must learn to eliminate to enjoy greater success. These are common buying mistakes that many investors make:-

1. Buying near a top
2. Buying during a down trend
3. Buying before a bottom is formed

The buying mistakes in 1 and 3 are caused mainly due to inexperience with technical analysis. In the majority of bull and bear markets, a top or a bottom just do not happen out of the blue. There is a process, usually accompanied by a clearly identifiable reversal pattern, through which a top or a bottom gets formed. Such reversal patterns may take a few weeks, or a few months to form.

In both the Sensex and the Nifty, the Nov ‘10 peaks were part of ‘diamond’ reversal patterns, which transformed into large ‘descending triangle’ reversal patterns. So, we actually had two reversal patterns to indicate a change of trend from bull to bear.

The 2008 bear market ended with a 5 months long rectangular reversal pattern. It is expected that the current bear market will also form an identifiable pattern before the next bull phase can start. No such pattern is visible yet.

It is easier to identify reversal patterns after the pattern is fully formed. But there are prior signals given by various technical indicators that help to ascertain whether a reversal pattern is in progress. It is better to err on the side of caution when stock markets are rising or falling fast.

Buying during a down trend is acceptable only if you are covering up an earlier sale at a higher price. Not otherwise. Unlike tops and bottoms, which are tougher to identify, a simple trend line or the 200 day EMA can show whether a stock or an index is in a down trend. The biggest mistake you can make is to think that ‘it can’t fall any lower’. Learn to be patient and stay away during down trends. Buy only after an up trend is re-established.

Is the recent stock market volatility unusual?

Before I answer that question, let me try and explain what volatility in the stock market really means. To the ordinary investor, volatility may mean sudden and unexpected changes in a stock’s price (or an index level).

But aren’t fluctuations in stock prices and index levels the norm rather than the exception? That’s an easier question to answer. Yes, stock prices and index levels do fluctuate all the time. But some times, the fluctuations are tolerable and ‘normal’. Those are periods of low volatility, which are conducive for trading and investments.

At other times, there are extraordinary and nerve-wracking fluctuations in stock prices and index levels that send traders and investors scurrying for cover. Such periods of high volatility increases risk and decreases returns.

For the mathematically inclined, volatility is a statistical measure of the uncertainty or risk associated with changes in a stock’s price (or an index level). It can be measured by using the standard deviation or variance (i.e. two standard deviations) of the returns from a stock or index.

A measure of the overall volatility of a stock’s return benchmarked against an index is called ‘Beta’. A Beta value of 1.0 means the stock’s return is the same as that of the index. In other words, if the index gains 100%, the stock will gain 100%. A Beta value of 1.5 means a stock will gain 50% more than the index during bull periods, but lose 50% more during bear periods; a value of 0.8 means the stock will gain 20% less than the index in a bull market, and lose 20% less in a bear market. The higher the Beta value, the more volatile the stock.

For the technically inclined, the Nifty VIX chart indicates the implied volatility (IV) of a basket of Nifty put and call options. A high VIX level (above 30) indicates high volatility; a low VIX value (below 20) indicates low volatility. Typically, when the VIX rises, the Nifty falls. The VIX can be used as a contra-indicator. Low values give an opportunity to sell, and high values provide opportunities to buy.

What causes high volatility? Unexpected changes - in interest rates (repo, reverse repo) or oil prices; a war or terrorist attack or earthquake; a change of government - can lead to wide fluctuations in stock prices and index levels.

What can small investors do? Understand this simple thumb-rule. Volatility declines when stock markets rise, and increases when stock markets fall. In a bear market – like now – high volatility is not unusual.

That is one reason why small investors may be better off staying away instead of trying to make a few bucks on counter-trend rallies; and avoid averaging-down during bear markets.

That was the long answer. The short answer to the question is: No.

Related Post

What is causing the volatility in the Sensex?

Stock Index Chart Patterns – S&P 500 and FTSE 100 – Sep 02, ‘11

S&P 500 Index Chart

The technical indicators of the S&P 500 index chart were showing positive divergences last week, which signalled that the relief rally may continue. But the rally was losing momentum, and I expected the index to face resistance from the falling 50 day or 200 day EMAs.

True to expectations, the index climbed past the 20 day EMA during the early part of the week, only to face strong resistance from the 50 day EMA. The poor jobs data – zero new jobs were added in Aug ‘11 – caused Friday’s sell off, but the index was already heading down.

The slow stochastic turned back after reaching its overbought zone. The MACD is above its signal line, but has started to fall in negative territory. The RSI is sliding down towards the 50% level. Looks like the relief rally from the low of 1100 has ended, and the S&P 500 will travel further south.

The PMI (Purchase Manager’s Index) Aug ‘11 reading was 50.6, down 0.3 from the July ‘11 figure, an indication that manufacturing growth is on the verge of stalling. The weekly unemployment claims were at 409,000 – lower by 12,000 from the previous week’s adjusted figure, but above the critical 400,000 mark. Unemployment level remained unchanged at 9.1%. The US economy needs jobs to grow, but hiring has been anaemic.

In an interesting twist to the employment story, a couple of small business CEOs who were hiring were interviewed on CNBC. One of them mentioned that a couple of potential candidates cancelled job interviews because their unemployment benefits got extended. The other CEO made the shocking comment that selected candidates were specifying their own joining dates! They were willing to join only after their unemployment benefits came to an end. To paraphrase Marcellus (Hamlet, Act 1, Scene 4): “Something is rotten in the United States of America.”

FTSE 100 Index Chart

The FTSE 100 index spent a couple of days above the 20 day EMA in a holiday-shortened week, but could not cross the hurdle of the 50 day EMA. The technical indicators are showing signs of weakness, with both the slow stochastic and the RSI turning down after rising above their respective 50% levels. The MACD is rising above its signal line, but remains negative.

UK’s PMI reading was 49.0 in Aug ‘11, down from 49.4 in Jul ‘11. Below 50 means contraction in manufacturing growth. The story was the same in the Eurozone, with the exception of Germany and Austria. In a report circulated to institutional investors, a Goldman Sachs analyst warned that European sovereign debt crisis is likely to get worse, and a large number of financial institutions are at the brink of an abyss. Not great news for the stock market.

At the time of writing this post, the FTSE 100 is trading 3.5% (almost 200 points) lower. The 5000 level is in danger of being breached.

Bottomline? S&P 500 and FTSE 100 chart patterns clearly show that relief rallies have come to an end. Both indices are likely to fall deeper into bear markets. Gold’s price is back up to the $1900 level. The flight to safety has resumed. Stay away.

BSE Sensex and NSE Nifty 50 Index Chart Patterns – Sep 02, ‘11

In a trading week truncated by two consecutive holidays, the BSE Sensex and NSE Nifty 50 index staged sharp rallies to move above their respective 20 day EMAs.

What caused the rally? Did the fundamentals of the market change suddenly? Actually, they worsened – because inflation rose back to double digits, opening the door for another interest rate hike later in the month. Stock markets abhor rising interest rates.

So, was the rally celebrating Anna Hazare’s ‘victory’? Maybe. The FIIs bought heavily, and that always boosts the market. Technically, the market was oversold, and a rally was on the cards. Reasons why the market is going up or down are always debatable. One should concentrate instead on the possible opportunities.

BSE Sensex Index Chart

The technical indicators were looking oversold last week and they were showing positive divergence with the index. That had indicated the possibility of a rally. The rally has corrected the oversold condition.

The MACD has crossed above its signal line, but is deep inside negative territory. The ROC is rising above its 10 day MA, but is yet to enter the positive zone. The RSI rose from its oversold zone to the 50% level, but faced resistance and turned down. The slow stochastic has managed to climb above the 50% level.

Can the rally continue? Yes, but it is losing momentum. Strong resistance is likely from the 17300 level (the lower edge of the descending triangle), and above it, from the gap and the falling 50 day EMA. The index may consolidate in the band between 17300 and the next likely support level of 15580 before deciding on its next move – which should be downwards.

NSE Nifty 50 Index Chart

The weekly bar chart pattern of the NSE Nifty shows a nice recovery after 5 straight lower weekly closes. The week’s volume bar doesn’t inspire much confidence – but that is because of the two holidays during the week.

The technical indicators are showing positive signs, but haven’t turned bullish yet. The MACD is negative and below its signal line. The ROC is also negative and below its 10 week MA, but trying to turn around. The RSI has emerged from its oversold zone, but is below the 50% level. The slow stochastic is still in the oversold zone.

Further up move will face resistance at the 5180 level – the lower edge of the descending triangle. In case the Nifty can climb back inside the triangle, the falling 20 week and 50 week EMAs may prove to be stronger resistances.

With Anna Hazare off the front page, the government should concentrate on taking policy decisions that will help economic growth. GDP growth is definitely slowing. In a high interest rate environment, capital investments are held back, and profit margins get squeezed leading to even lower growth.

Bottomline? The BSE Sensex and NSE Nifty 50 index chart patterns staged relief rallies last week, correcting oversold conditions. Such counter-trend rallies are selling opportunities. Global growth is slowing, and that is never a good sign for stock markets. Both indices are in bear markets, which means one should avoid trying to be brave.

European indices: crack under severe bear attacks

We keep reading and hearing about the poor economic growth and sovereign debt problems in Europe. One would expect the stock markets to perform badly. But through the past 12 months, most European indices have performed remarkably well – while the Indian stock market has been in a 10 months long down trend despite much better economic growth.

Things have changed of late. Even as our stock indices continue to struggle in bear markets, European indices have cracked under severe bear attacks. Most have dropped below their 2010 lows. Some have slipped to 2 year lows. The charts will tell the story:

Austria ATX

Austria’s ATX index peaked at 3000 back in Feb ‘11 and started correcting. The ‘death cross’ in Jul ‘11 confirmed a bear market. A vertical fall has dropped the index to a 2 year low in Aug ‘11. A ‘dead cat bounce’ has been followed by more selling. The index has lost more than 30% from its peak.

France CAC 40

France’s CAC 40 index has fared marginally better than Austria’s index. It dropped just under 30% from its peak, but also to a 2 year low.

Germany DAX

Germany’s DAX index had been a spectacular performer, till the first big crack appeared in Mar ‘11. The index went on to touch a peak of 7500 in May ‘11. A period of sideways consolidation concluded with a vertical drop to the Feb ‘10 low. The index has lost about 28% from its peak.

Holland AEX

Holland’s AEX index has fallen to a 2 year low, losing about 27% from its Feb ‘11 peak. The ‘death cross’ confirmed a bear market in Jun ‘11, so the recent crash should not have come as a big surprise.

Norway OSEAX

Norway’s OSEAX index has corrected more than 25% from its Mar ‘11 peak, but found support near its Aug ‘10 low. It is trying to consolidate before resuming its down move.

Sweden OMXSPI

Sweden’s OMXSPI index has also corrected more than 25% from a double-top at 375 to levels last seen in Oct ‘09.

Switzerland SMI

Despite the strength of the Swiss franc, Switzerland’s SMI index has been correcting since hitting a peak near 7000 back in Apr ‘10. More than a year’s sideways consolidation within a rectangle culminated in the ‘death cross’ in Jun ‘11.

Some experts on business TV channels have opined that FIIs will have no choice but to buy in India and other emerging markets - to chase growth that is lacking in their home markets. I have my doubts. FIIs would be less interested in chasing growth. Their main job will be to protect capital. That means booking profits in emerging markets to cover up the losses in their home markets. Their selling in India may continue till the global economy starts showing clear signs of recovery.

BSE Sensex and NSE Nifty 50 Index Chart Patterns – Aug 26, ‘11

Last week, I had analysed the two gaps (labelled GAP1 and GAP2) on the chart patterns of the BSE Sensex and the NSE Nifty 50 indices. The following conclusions were drawn:

1. GAP1, a ‘breakaway’ gap from a bearish descending triangle pattern, was unlikely to get filled in a hurry
2. GAP2 was a ‘common’ gap that both indices were likely to fill on an upward bounce over the next two trading days
3. Bears would use the upward bounce to sell
4. Both indices would consolidate for a while before resuming the downward journey.

Some times, technical analysis can be almost prophetic. ‘Almost’ because the first three events happened exactly as per expectation; but not the fourth. GAP2 got filled during the first two days of the trading week. The down trend resumed immediately, and ended the week by breaking below the May ‘10 lows (15960 for the Sensex and 4786 for the Nifty).

BSE Sensex Index Chart

How important is the break below the May ‘10 low of 15960? Not very – other than indicating that the Sensex is ready to fall lower. During down trends, supports occur at previous tops. While a previous bottom is like a milepost on the way down, it usually acts as a resistance during future up moves. It may be worthwhile noting that.

Which are the previous tops from which the Sensex can seek some support? The Jun ‘09 top of 15580 is the nearest one. Below that is the likely support from the May ‘09 top of 14930. That is barely 5% below this week’s closing level! Can the index go down further to fill the big gap formed in May ‘09? The top level of that partly-filled gap is at 13220. Nothing can be ruled out. A fresh look can be taken if and when 14930 (the May ‘09 top) is breached.

The technical indicators are looking very bearish, and oversold. Note that the ROC, the RSI and the slow stochastic reached higher bottoms as the Sensex dropped to a new low. The positive divergences should lead to an upward bounce. The way FIIs are selling at every rise, any rally may be short-lived.

NSE Nifty 50 Index Chart

The weekly bar chart pattern of the Nifty 50 index clearly shows five straight lower weekly closes. It is a good time for a counter-trend rally. Will it happen?

The weekly technical indicators are looking oversold, so a rally is a possibility. Note that the weekly RSI hardly spends any time in the oversold zone. In the past year, it had spent only one week in Feb ‘11. Now it has remained in the oversold zone for two straight weeks.

Please remember that the ‘death cross’ of the 20 week EMA below the 50 week EMA has confirmed a bear market. That means, any counter-trend rally will be a selling opportunity. For likely lower Nifty levels, check out my post of Aug 24 ‘11.

Food inflation seems out-of-control. Daily use vegetables (except potatoes) cost Rs 40 – 60 a Kg in Calcutta. Last year, they were in the Rs 30 – 40 a Kg range. The Anna Hazare anti-corruption demonstration has tied up the Parliament in knots - to the point where important and necessary policy decisions are not forthcoming. Unless the Lokpal Bill is tabled soon, stock markets will slide, as FIIs will continue selling.

Bottomline? The BSE Sensex and NSE Nifty 50 index chart patterns are falling deeper into bear markets. Any upward bounce next week may only prolong the pain. Stay on the sidelines and start brushing up on analysis and stock-picking skills.

Which stocks are dragging the Sensex down?

The Sensex closed well below its May ‘10 low today, and the talking heads in the business channels had grim looks on their faces and kept saying “It’s a very bad day”, and “It’s a terrible start to the Sep series”! They should have said: “What a great day for the bears”, or, “What an opportunity for those who sold at higher prices”. Guess they are pre-programmed to feel sad when the market falls.

I took a quick look at the weekly charts of the Sensex constituents (except Coal India, which is a recent listing and doesn’t have adequate trading data).

Only seven stocks are trading above their rising 50 week EMAs (equivalent to the 200 day EMA on daily charts) indicating bull markets. These seven have prevented the Sensex from falling much lower. Here are the ‘Magnificient Seven’ (you can check out a terrific Western of the same name featuring Yul Brynner, Steve McQueen, Charles Bronson, over the weekend; the movie is based on a Kurosawa classic: ‘Seven Samurai’).

Stocks trading above rising 50 week EMAs

1. Bajaj Auto
2. Bharti Airtel
3. Hero Motocorp
4. Hind. Unilever
5. ITC
6. Mahindra and Mahindra
7. Sun Pharma

The balance twenty-two stocks are trading below their 50 week EMAs indicating bear markets. These are the stocks that are dragging the Sensex down.

Stocks trading below 50 week EMAs

1. BHEL – at level of Apr ‘09
2. Cipla – at level of Oct ‘09
3. DLF – at level of Mar ‘09
4. HDFC – still above Feb ‘11 low
5. HDFC Bank – still above Feb ‘11 low
6. Hindalco – near Jun ‘10 low
7. ICICI Bank – at level of May ‘10
8. Infosys – at level of Oct ‘09
9. Jaiprakash – at level of Mar ‘09
10. Jindal St. and Power – at level of Jul ‘09
11. L and T – still above Feb ‘11 low
12. Maruti – at level of Jul ‘09
13. NTPC – at level of Dec ‘08
14. ONGC – still above Feb ‘11 low
15. Reliance – at level of Mar ‘09
16. SBI – at level of Feb ‘10
17. Sterlite – at level of May ‘09
18. TCS – at level of Sep ‘10
19. Tata Motors – at level of May ‘10
20. Tata Power – at level of May ‘09
21. Tata Steel – at level of Aug ‘09
22. Wipro – at level of Aug ‘09

What conclusions can be drawn from the above two lists? The seven that are still in bull markets will probably be the next target for the bears. The ones that have fallen the most, can give bigger percentage rises when the market turns eventually. Provided of course, that their fundamentals haven’t worsened. It does not mean that they can’t fall even further from current levels.

Small investors who do not own large-cap stocks can use the lists to short-list the fundamentally stronger ones and start accumulating slowly. But have a two-three years time-frame in mind. Please do not expect to get rich quick.

About Nifty Fibonacci retracement levels

During the previous bear market in 2008, I had written a post: ‘How low can the Sensex go?’, where the concept of Fibonacci retracement levels was introduced. Now that the Indian stock market has entered a bear phase once more, it may be a good time to revisit Fibonacci levels to get an idea of how low the Nifty may fall.

The assumption here is that the entire bull rally – from the closing low of 2573 on Mar 9 ‘09 to the closing high of 6312 on Nov 5 ‘10 – is being ‘corrected’. The Nifty had an up move of (6312 – 2573 =) 3739 points, which can be rounded-off to 3740 points.

The respective Fibonacci retracements are:

1. 38.2% of 3740 = 1428 points
2. 50% of 3740    = 1870 points
3. 61.8% of 3740 = 2311 points

So, the retracement levels are:

1. 6312 – 1428 = 4884; say, 4900
2. 6312 – 1870 = 4442; say, 4450
3. 6312 – 2311 = 4001; say, 4000

These levels have been marked on the Nifty closing chart below:

How sacrosanct are these Fibonacci retracement levels? No level is sacrosanct where the market is concerned. It can go anywhere and stop anywhere. But after studying hundreds of charts over many many years, the gurus of technical analysis discovered that markets tend to turn around near Fibonacci retracement levels – both in bull and bear markets.

So, how far down will the Nifty go? The 38.2% retracement level is where we are at now. Can it bounce up from here? Looking at the state of the global and Indian economies, and the weakness in the Nifty technical indicators, the answer is ‘no’.

The next likely support is near the 50% retracement level of about 4450. If that is broken, then the Nifty may go down to the 61.8% retracement level of 4000. Interestingly, 4000 is not only the downward target from the break out below the large descending triangle on the Nifty chart, it is also the top of the huge gap formed on the chart in May ‘09 (not visible in the closing chart). Such ‘coincidences’ make technical analysis a lot of fun.

Can the Nifty fall below 4000 to close the gap? Very unlikely, but not impossible. In Oct ‘08, the Sensex dropped to 7700, which was well below the 61.8% retracement level of 9900. What is the likely level where the Nifty may find support?

Note that the Fibonacci retracement levels are just some numbers calculated on the basis of empirical observations. More realistic support levels are at or near previous tops. The Jun ‘09 and Aug ‘09 tops occurred near 4700. The top on May 18 ‘09 was 4323 and that on Jul 3 ‘09 was 4424 (very close to the 50% retracement level). So, we can expect the Nifty to turn around from the zone between 4300 and 4700.

What should small investors do? Avoid buying or selling in a panic. If you didn’t book profit at 6300 or 5900, don’t start selling now. If you are planning to invest in an index fund or Nifty BeES, start accumulating below 4700. As far as individual stocks are concerned, carry out this same exercise on their respective charts to decide on entry points.

Stock Index Chart Patterns – S&P 500 and FTSE 100 – Aug 19, ‘11

S&P 500 Index Chart

The S&P 500 index chart was expected to regain some lost ground last week. It managed to close above the 1200 level on Mon. Aug 15 ‘11 and went above the 1200 level intra-day on Tue. and Wed., but that was all that the bulls could manage against sustained selling.

The falling 20 day EMA was supposed to provide the first level of resistance to any up move, and the 50 day EMA was expected to cross below the 200 day EMA – the dreaded ‘death cross’ that confirms a bear market. Like a good Hollywood film director, the bears ensured that events followed exactly according to the script. Friday’s fall was accompanied by the highest volumes of the week – an ominous sign. The only silver lining (for the bulls) is that the 1100 level has not been breached as yet. But that may be a temporary respite.

The technical indicators are turning bearish again. Both the slow stochastic and the RSI emerged from their oversold zones, but are turning back well before reaching their 50% levels. The MACD is below its signal line, and sinking deeper into the negative zone. At the time of writing this post, the index is trying to stage a rally. It will be another selling opportunity for the bears.

Economic news remained dismal. Initial jobless claims rose by 9000 to 408,000. Existing home sales dipped by 3.5%. Philly Fed’s regional growth index dropped sharply from +3.2 in July to –30.7 in August (negative number means contraction). Morgan Stanley cut its global GDP forecast to 3.9% from 4.2% for 2011, and to 3.8% from 4.5% for 2012.

FTSE 100 Index Chart

The FTSE 100 index closed above the 5350 level on Mon. and Tue. last week before the bears decided enough was enough. Friday’s (Aug 19 ‘11) high volume selling pushed the index below the 5000 level intra-day, but short-covering helped the index to close above 5000.

The FTSE 100 last closed below the 5000 level more than a year ago – so the bulls are trying to defend the level with all their might. The technical indicators have started to weaken, with the RSI and the slow stochastic heading down towards their oversold zones once again, and the MACD is falling in negative territory. Any up moves will attract more selling.

Unemployment is rising again. No wonder retail sales are falling. The stock market is finally realising that there will be a prolonged period of little or no growth and low inflation. Stocks are being dumped for safer havens like gold and treasuries.

Bottomline? The S&P 500 and FTSE 100 chart patterns are in confirmed bear markets. Selling on every rise and buying back on the dips should be the strategy - till the charts show clear signs of reversal. No such signs are visible now.

BSE Sensex and NSE Nifty 50 Index Chart Patterns – Aug 19, ‘11

In a post back in Sep ‘09, I had written about the four different types of gaps that form in stock and index chart patterns, and their implications. There is a common myth that gaps should get filled. While eventually most gaps do get filled, this is not a ‘rule’. Gaps can remain unfilled for months and years. Some times they get partially filled (as in Jul ‘09). On rare occasions, they do not get filled at all.

We can now see two distinct gaps – marked by light blue ovals and labelled GAP1 and GAP2 – on the one year BSE Sensex bar chart pattern below. What can be the implications of the two gaps?

BSE Sensex Index Chart

GAP1 is obviously a ‘breakaway’ gap. Why? Because it marked the break out below a prolonged descending triangle pattern. It was also accompanied by strong volumes. That means two things: 1) the break out wasn’t a ‘false’ one; 2) GAP1 may not get filled in a hurry, though it may get partially filled.

What about GAP2? Note that prior to forming the second gap on Fri. Aug 19 ‘11, the index spent about 9 trading sessions in a small rectangular consolidation zone. The gap was accompanied by strong volumes, which makes it another ‘breakaway’ gap. But we already have one ‘breakaway’ gap (GAP1).

Can GAP2 be a ‘runaway’ (or ‘measuring’) gap that marks the mid-point of a move? Unlikely, because ‘runaway’ gaps tend to form at the mid-point of almost straight line moves (up or down). This gap came after a brief consolidation.

Can it be an ‘exhaustion’ gap marking the end of the current down move? Anything is possible in the market – but ‘exhaustion’ gaps are rarely the next gap after a ‘breakaway’ gap.

The process of elimination leaves us with a ‘common’ or ‘area’ gap, which forms within a consolidation zone. That means, GAP2 will probably get filled soon. The Sensex may consolidate sideways between 16000 and 17300 for a while, and raise bullish hopes before resuming its southward journey. If GAP2 is not filled within the next two trading days, then the downward slide will continue.

Please remember that technical analysis deals with possibilities and probabilities – not certainties. There is no rule that says GAP2 can’t be a second ‘breakaway’ gap. It can also be a ‘runaway’ or ‘exhaustion’ gap. These are interesting times for chart pattern watchers, even though they may be painful for investors.

NSE Nifty 50 Index Chart

The Nifty 50 chart tested the May ‘10 intra-day low of 4786 when the index dropped to 4796 on Fri. Aug 19 ‘11. The strong volumes indicate bear dominance. There is stronger support at 4730, which corresponds to the Aug ‘09 top.

The technical indicators are looking very bearish, pointing to a deeper correction. The MACD is falling below its signal line, further into negative territory. The ROC is below its 10 day MA and also falling in negative territory. Both the RSI and the slow stochastic are inside their oversold zones.

There is a sliver of silver lining. The ROC, RSI and slow stochastic didn’t touch lower bottoms even though the Nifty dropped to a new 52 week low. The positive divergences could lead to an upward bounce to fill the gap between 4932 and 4894 formed last Friday. But any such upward bounce will be a selling opportunity.

July inflation figure came in a bit lower at 9.22. The June figure was 9.44. But the May figure was revised upwards from 9.06 to 9.56, so the market took the lower July figure with a pinch of salt. Another 25 bps rate hike in Sep ‘11 is a distinct possibility. Market experts made a song-and-dance that the current FII selling is only due to the continuing economic turmoil in USA and the Eurozone, and has no connection with India’s economic situation.

The fact is, our domestic situation is not very conducive for buying shares. Higher interest rates have trimmed corporate margins and slowed down growth. A series of scams have put much-needed economic reforms on the back-burner. The Anna Hazare anti-corruption agitation has struck a chord among the youth, and come as a ‘manna’ from heaven for the hitherto sidelined opposition parties. The government has pushed itself into a corner with its ham-handed treatment of the agitators, and is desperately trying to project a ‘zero tolerance to corruption’ approach.

To cut a long story short, the near-term outlook is uncertain; and investors hate uncertainty. No wonder FIIs are selling big time, and investors are flocking towards gold and gold ETFs as comparatively safer havens.

Bottomline? The BSE Sensex and NSE Nifty 50 index chart patterns are now in technically confirmed bear markets. You make money in a bear market by selling short and then buying back at lower prices. But this is a strategy suitable for experienced investors only. Newer entrants should sit out the correction.

Stock Chart Pattern - 3i Infotech Ltd (An Update)

The previous technical update of the stock chart pattern of 3i Infotech was posted exactly one year back. The stock had dropped from an intra-day peak of 103 in Oct ‘09 to close at 63 on Aug 17 ‘10, and was in a bear market. My concluding comments were:

‘If you are still holding the stock, get out at the earliest opportunity. The stock can fall much lower.’ 

And so it has – as a look at the one year closing chart pattern of 3i Infotech will confirm:

Shortly after I wrote the previous update, the stock price slid to a low of 58 on Aug 31 ‘10. Note the oversold conditions in the RSI and slow stochastic. A rally ensued, which found initial resistance from the 20 day and 50 day EMAs. Strong volumes enabled the stock price to reach the falling 200 day EMA, with a few isolated closes above the long-term moving average.

On Nov 11 ‘10, the stock touched an intra-day peak of 72 but it turned out to be a high volume ‘reversal day’ that extinguished the last flickering bullish hope. The stock dropped to an intra-day low of 38 on Feb 10 ‘11, and then started a ponderous rally that touched an intra-day high of 54 on Jun 6 ‘11 – just above the falling 200 day EMA, only to close much lower at 48.

It has been all downhill ever since. All four technical indicators are looking extremely bearish and oversold. But a stock can remain oversold for long periods. At today’s closing level of 28, it is just 10% above its bear market low of 25 – touched on Mar 12 ‘09. There is every possibility of the stock price falling below 25 and turning into a penny stock.

The company is still grappling with a huge debt burden, and had to sell off one of its US acquisitions to help clean up its balance sheet. But there is a long way to go. The slow growth of the US and Eurozone economies will continue to hamper its export business.

Bottomline? The stock chart pattern of 3i Infotech is an example of how a company with good pedigree and business model can come unstuck because of over-leveraging in an effort to become too big too fast. This is not a contrarian pick. Stay away.

Use a Stock Screener to make a ‘buy’ list

The down trends in the Sensex and Nifty index charts have completed nine months, and are showing no signs of reversals. In fact, relentless selling by the FIIs in August ‘11 has turned a bad situation (from the bullish point of view) even worse.

Any sensible investor would stay far away from buying in a stock market that is showing all the signs of a full-fledged bear market. So, why a post about making a ‘buy’ list? If you have participated in the Boy Scout movement, then you wouldn’t need an explanation. The motto of the Boy Scouts is: ‘Be Prepared’.

Just as all good things must come to an end – like the heady bull run from the Mar ‘09 low did when it peaked out in Nov ‘10, bad times don’t last forever. In the not too distant future, inflation rates will start to moderate and interest rates will be lowered. The stock market will ‘discount’ the good news in advance and start to rise much earlier. That would be a good time to buy – provided you are ready with a ‘buy’ list.

Small investors face a big problem. With thousands of company stocks traded in the stock market, how does one begin to make a short-list of stocks for more detailed research? This is where a Stock Screener can come in handy. What is a Stock Screener? It is a software that allows you to use certain fundamental criteria to make a short-list of stocks that meet those criteria.

Which Stock Screener should you use? Every financial site probably has one, so there is a lot of choice. You have to do a bit of trial and error to find out one that works well for your style of investing. You can start with the Stock Scanner available at the BSE web site:

http://www.bseindia.com/stockscanner/stockscanner.aspx

It is quite rudimentary, and has only four fundamental criteria that you can use: Last traded price (LTP), Market Capitalisation, EPS and P/E. Each of the four criteria has a range of values to further fine tune your search. Try out with different permutations and combinations to arrive at a short-list from all the stocks traded on the BSE.

Edelweiss has a Stock Screener (as do many other such sites):

http://www.edelweiss.in/Tools/screener.aspx#

This also has four fundamental criteria, with Dividend Yield in place of LTP. An additional feature is you can short-list by specific sectors. If you don’t mind registering at the site (it is free, but you will get periodic mailers), then you can add more criteria for your short-listing.

Let me add here that I’m not a great fan of Stock Screeners – mainly because the criteria I use for short-listing are not available in most of the free software. In any case, you have to do a detailed study of each short-listed stock to find out if it merits a place on your ‘buy’ list.

A Stock Screener can be a good first step for short-listing stocks for making a ‘buy’ list. Be sceptical of unknown stocks that get short-listed. Don’t think that you have ‘discovered’ a hidden gem that the whole world has missed. If you keep trying different combinations, you may get lucky and stumble upon an undervalued stock.

Happy hunting!