The SENSEX is still finding good support at the 2006 post sell-off lows. We could be in the midst of forming a bottoming pattern, possibly a double bottom. It’s vital the supports near the recent lows hold. We are heading into a critical few days/weeks for the SENSEX in technical terms.

Near term technical signals are mixed and you can find a daily update on my website at www.reutersindia.net

On the second longer term chart you can clearly see the support. You can also see on the sub-chart the 10-day close-to-close volatility (see note 1) study is coming off the high very quickly. High volatility coincides with market turning points, note the past price action. Each time there is a peak in volatility the price action turns. Given what is happening now we could be seeing another peak and another turning point.

Now to the correlations the SENSEX has with other markets. The third chart is the SENSEX’s correlation with the Asia MSCI – ex Japan (see note 2) index it is still high as you can see. I’m using the MSCI as proxy but the picture is similar if you use the U.S. S&P 500 or even the Dow Jones vs the SENSEX.

From this chart you can see the last time the SENSEX was moving under its own steam was when the government won the vote of confidence and the correlation dipped to negative (see note 3). Since then, it has simply been pulled around by the influence of overseas markets. Global trends are important to India at the moment, not domestic economic or political factors.

It’s important to watch the INR as the correlation with stocks is very high indeed, as stocks fall the rupee follows and vice-versa. That said, stocks are leading the INR via foreign investment flows. Therefore, this chart is of more use to anyone with an interest in INR rather than stocks.

Note 1 - Volatility - Warn of a potential change in trend. If a market is trending and the volatility is high, a drop in volatility may be a warning that the trend is coming to an end and the market will move into a trading range. If a market is in a trading range with very low volatility, an increase in volatility may be the first warning of a change in market trend from non-trending to trending. Confirmation that the trend has changed will need to come from price action, for example a close above/below an important resistance/support level.

Note 2 - The MSCI AC (All Country) Far East ex Japan Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the Far East, excluding Japan. As of June 2006 the MSCI AC Far East ex Japan Index consisted of the following 9 developed and emerging market country indices: China, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore Free, Taiwan and Thailand.

Note 3 - Correlation - Determine the predictive ability of an indicator. When comparing the correlation between an indicator and an instrument’s price, a high positive coefficient (e.g., more than +0.70) tells you that a change in the indicator will usually predict a change in the instrument’s price. A high negative correlation (e.g., less than -0.70) tells you that when the indicator changes, the instrument’s price will usually move in the opposite direction. Remember, a low (e.g., close to zero) coefficient indicates that the relationship between the instrument’s price and the indicator is not significant.
Determine the correlation between two securities. Correlation analysis is also valuable in gauging the relationship between two instruments. Often, one instrument’s price “leads” or predicts the price of another instrument. For example, the correlation coefficient of gold versus the dollar shows a strong negative relationship. This means that an increase in the dollar usually predicts a decrease in the price of gold.

Markets are driven primarily by fear and greed and we’ve seen both in equal measure over the past few years. Greed as people borrowed money and piled into stocks for instant riches, and fear now everything is lost, and more if investments were leveraged.

It has happened before. It was the same in the 1980s and the crash of 1987 and the NASDAQ bubble of the late 1990s. As a cub reporter in Fleet Street I covered the ‘87 crash and investors’ attitude then was exactly the same as it is now and I’m hearing and reading the same reactions.

Boom-bust has happened before and will undoubtedly happen again for similar, or different reasons, but history will repeat itself.

The major lesson a savage market correction has for retail investors, short and long-term alike, is to have sensible timescales and aspirations and take profits when they seem reasonable. If you let your bet ride in a game of roulette, you could get super rich but you could lose the lot.

A professional trader will tell you there is no such thing as a bad profit and banking them, even small ones, is no bad thing. A SENSEX investment in early 2006 at 10,000 had gained 100 pct within two years and by any standards that is a colossal gain for a stock market. Even without the credit crisis the market was anyway staging a much needed correction to a hugely overbought position.

The nice bounce the SENSEX had at the 12,500 level ran slap bang into an unknown in the form of the scale of the credit crunch fallout and the market has retraced back to where it is now, around 2/3 of its entire upmove. (See first chart)

The market has run into quite nice technical support around the 2006 post sell-off low as you can see. You can also see that the close-to-close volatility is still very high. Spikes in volatility usually happen around market turning points and you can see evidence of this on the chart.

On the second chart you can see short-term indicators like the Parabolic-SAR has touched the price action and will now switch to bullish and the MACD has crossed which is also bullish. The Alpha-Beta trend is still in downtrend.

We need better confirmation but the turning point signs are good at the moment.

The last chart, just as a matter of interest, is the U.S. Federal Funds rate versus the Dow Jones index over the past 10 years. You can see the how the Fed Funds rate was cut during the 2000/2001 recession clearly and the similar picture we are seeing now.