Will the market crash if Nifty falls below 5200?

What is the point of asking this question when the Nifty closed above the 5400 level today? Regular readers may have the answer to the second question: Because the Nifty has formed a large ‘descending triangle’ pattern from which the likely break is downwards through the horizontal support level of 5200.

The one year bar chart pattern of the Nifty clearly shows the large descending triangle:

  

To try and attempt an answer to the first question, we need to look at some of the technical ‘rules’ associated with triangles. If you are new to technical analysis, it may be worth mentioning that there is nothing technical about ‘technical analysis’. It is just a name. A better name would be ‘sentiment analysis’ or, better still, ‘supply and demand analysis’.

Price charts tend to form certain patterns based on the supply and demand for individual stocks. In the case of an index, the patterns are formed by the combined supply and demand for stocks that are included in an index. The ‘rules’ for certain patterns are based on observations made over many many years of stock and index charts.

What are the rules associated with a ‘triangle’ pattern?

1. A triangle is a ‘consolidation’ or a ‘continuation’ pattern. That means, the previous price trend consolidates within the triangle before continuing in the same direction as its earlier price trend. Sometimes, a triangle can be a ‘reversal’ pattern; i.e. a previous up trend becomes a down trend (and vice versa).
2. An upward price break out from a triangle should be accompanied by an increase in transaction volumes. But a downward break out need not be accompanied by higher volumes. If an upward break out happens on weak volumes, it may lead to an ‘end run’ or a ‘false’ break out. If a downward break out is accompanied by high volumes, it may be a ‘shake out’ or a ‘bear trap’.
3. A break out – in either direction – should happen within two-thirds or three-fourths of the perpendicular distance between the base and the apex of the triangle.
4. In the case of right-angled triangles, price break out occurs through the flat side; i.e. upward from an ‘ascending triangle’ (flat top and rising bottoms), and downward from a ‘descending triangle’ (flat bottom and falling tops).
5. Triangles seem to lose their ‘power’, the closer the prices get towards the apex. Some times prices move right through the apex without a clear break out in any direction.
6. Triangles have measuring implications. On an upward break out, an upward sloping line is drawn parallel to the lower side; on a downward break out, a downward sloping line is drawn parallel to the upper side. The height of the triangle will be equal to the extend of the upward or downward move following the break out.

Since we have a clear descending triangle pattern on the Nifty, let us evaluate the rules to arrive at the most likely occurrence.

If we extend the downward sloping trend line and the flat bottom of the descending triangle to the right of the chart above, the apex will be formed around 5 months from now; i.e. in early Jan ‘12. The triangle started forming from the peak of Nov 5 ‘10, so the distance to the apex of the triangle in terms of time will be about 14 months.

A break out should happen within two-thirds (9 months 10 days) and three-fourths (10 months 15 days) of the distance to the apex from Nov 5 ‘11. That gives the period between Aug 15 and Sep 20 ‘11 within which a downward break out should occur. A break out may occur even earlier. The measuring implication will be the height of the triangle, which is 6340 (Nov 5 peak) – 5180 (Feb 11 trough) = 1160 points. So, the Nifty can drop to (5180 – 1160 =) 4020. That will be the worst case scenario.

If the downward break out is accompanied by high volumes, then the Nifty can turn around and resume its up trend by shaking out the bears. There is a possibility that the Nifty consolidates within the triangle beyond Sep 20 ‘11 and breaks out closer to the apex. In that case, it may fall only till 4840 (its May ‘10 low). A break out above the triangle is also a possibility – but should be accompanied by high volumes. The other possibility is that the Nifty continues to drift sideways and fizzles out through the apex of the descending triangle.

The answer to the original question is: It may do so. In technical analysis, there are no certainties – only possibilities and probabilities. A downward break out with a drop to 4840 is the most probable outcome. But a drop to 4020 can not be ruled out by any means.

What should small investors do? Keep a close watch on portfolio stocks and the 5200 level in the Nifty. The technical indicators are looking bearish – signalling a downward break below 5200.

Seek opportunities in this HDFC fund

The HDFC Mutual Fund house has been one of the best performers in the Indian market with several 5-star rated funds under management. Some of these funds have track records of 10-15 years. That means they have been through two bull-bear cycles.

However, a younger fund – barely 4 years old – has been performing quite well. The HDFC Mid-Cap Opportunities Fund (HMCOF) caught my eye because of several interesting allocation features in terms of percentage of net assets. These are listed below:

1. Mid-Cap companies:   70-95%
2. Small-Cap companies: 5-15%
3. Other equity/related:  0-25%
4. Debt/money market:   0-25%
5. Derivatives (equity/debt): 0-20%
6. Foreign securities: 0-25%

With such a wide array of investment options, the fund managers - Chirag Setalvad and Miten Lathia (dedicated for overseas investments) - have a lot of lee-way in playing around with different permutations and combinations to achieve optimum returns. What kind of returns have they provided so far?

Not bad at all. One year CAGR  of 11.58%, three years CAGR of 22.85%, and return since inception (in June 2007) of 12.9%. During the bear market period of 2008-09, the fund dropped 38.1%, outperforming its benchmark index CNX Midcap (which fell 45.4%).

One of the problems faced by many small investors is that they have limited capital. The large-cap ‘A’ group stocks appear to be too expensive – both in terms of price and value. Instead of buying a small quantity of a large-cap stock, investors have a propensity to buy larger quantities of mid-cap and small-cap stocks. While such stocks can provide great returns during bull markets, they tend to crash through the floor in bear markets.

The HDFC Mid-Cap Opportunities Fund seems to be tailor-made to solve the above problem. The flexibility of hedging the portfolio through derivatives, and by adding debt/money market instruments and foreign securities helps to protect the down side to an extent.

The fund’s portfolio of mid-cap stocks should make any knowledgeable investor drool. Here are some of the top stock holdings:

1. Ipca Laboratories
2. Carborundum Universal
3. Bata
4. Lupin
5. Exide
6. Vesuvius
7. Federal Bank
8. Union Bank of India
9. TTK Prestige
10. Tube Investments
11. Glaxo Consumer
12. Divi’s Lab
13. Sundaram Fasteners
14. Tata Chemicals
15. FAG Bearings

The fund also holds Crompton Greaves and Biocon, which haven’t performed all that well. A small amount invested regularly in HMCOF gives an exposure to some of the best known mid-cap companies that one can think of.

Stock Index Chart Patterns – S&P 500 and FTSE 100 – Jul 29, ‘11

S&P 500 Index Chart

The S&P 500 index chart dropped like a stone - almost to the 200 day EMA, thanks mainly to the uncertainty surrounding the debt ceiling wrangle in Washington DC. The ‘resolution’ of the self-made debt crisis over the weekend may cause a temporary relief rally, but market sentiment appears to have taken a hit.

The index is again trading below its 20 day and 50 day EMAs, and has formed a bearish pattern of lower tops and lower bottoms. In spite of the rising 200 day EMA, the S&P 500 has been trading within a sideways range between 1250 and 1370 for the past 6 months.

The technical indicators have weakened. The slow stochastic is about to enter its oversold zone. The MACD is below its signal line and about to slip into negative territory. The RSI is below the 50% level. The contours of the debt deal in Washington will determine market direction this week.

The economy continues to sputter without much movement. Initial unemployment claims edged below the 400,000 mark after 15 weeks. The AAII Sentiment Survey showed bullish sentiment at a 5 week low of 37.8%, and bearish sentiment at a 5 week high of 31.4%. The University of Michigan Consumer Sentiment index at 63.7 was the lowest since Mar ‘09. Q2 GDP growth was a paltry 1.3%.

FTSE 100 Index Chart

The technical indicators were flashing alarm signals last week. It came as no surprise when the FTSE 100 dropped below the 200 day EMA. The index just about managed to close at the level of the long-term moving average at the end of the week.

There may not be much respite for the bulls. The slow stochastic is below the 50% level and headed down. The MACD is below the signal line and barely positive. The RSI is below the 50% level. The good news is that the 200 day EMA is still rising, and the FTSE 100 index is trading within the six months long sideways range between 5600 and 6100.

The less said about the UK economic recovery, the better. Q2 GDP growth was a miniscule 0.2% – much below expectations. If growth falters any further, policymakers may not have many options left. The austerity measures are clearly not working.

Bottomline? The chart patterns of S&P 500 and FTSE 100 indices are trading sideways with a slight upward bias for the past 6 months. The respective economies are growing, but ever so slowly. Stay invested, with stop-losses at the lower edge of the respective trading ranges. The intrepid can choose to trade the ranges.