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.

A very nice key day reversal pattern on Wednesday completed on Friday. So far it is a textbook classic with Wednesday’s higher high and lower low but close near the high and Thursday’s lower high and higher low with a close near the low.
With this key day reversal you can see the MACD fast line, the green one, has the makings of an upturn. Short-term indicators are still bearish with the Parabolic-SAR, MACD and Alpha-Beta trend all pointing to the downside but we must watch for these to change and to call the turn. Despite this possible key day reversal, it’s too early to call a short-term trend change but keep an eye on these indicators for clues in the coming days.
The index is now well below the 38.2 pct Fibonacci retracement of the entire low to high move of the BSE. From a technical point of view this close below is not good news and the next big support level is 11,900. This is the level you keep reading about in the newspapers ‘at around 12,000.’ Lots of people are quoting it without really knowing why it’s important.
I think the thing that worries me most is that people are trying to call the end to this correction to the day or a particular level and that is a dangerous game. Technicals give good signals for turning points within 10-15 pct of the trend change. Sometimes you are lucky and the signals are strong, as with the January downturn. But with fundamentals so bearish at the moment - oil price, inflation, politics, weak world markets, US economic downturn - it would be well to get good technical confirmation of a bottoming out.

The support for the SENSEX at 14,677 and the possible double bottom formation we were looking at has broken in the wake of the surprisingly big jump in inflation. It has been obvious for months that official inflation numbers were not giving a true reflection of what was actually happening but even the highest forecasts were around 50 basis points off the 11.05 percent reported for the 12-months to June 7. It wasn’t that long ago that many pundits were saying the repo rate would not have to be raised so we are facing a situation now that many investors both onshore and offshore did not expect only a short while ago.
So support has broken and thus the longer term picture has clouded. The 14,677 level was key and all the short-term technical indicators I’ve been looking at are bearish under the rules of the various studies.
These are marked on the first chart and at the end of the article I have described briefly the rules of the studies.
The Parabolic-SAR dots have moved back to above the price action indicating a switch to a short position.* The MACD lines are moving down and apart ** and the Alpha-Beta signal, or filter, line is above the upper line and declining.*** The 14-day RSI is in oversold territory so that should help limit the near-term downside but it has in the past moved lower than it is now.****
So much for the short-term indicators, what about the longer term ones? We are currently sitting right on the 38.2 pct Fibonacci retracement of the entire low to high move of the BSE as you can see from the second chart. From a technical point of view this Fibonacci level is not that strong, as the trend had some good corrections on the way up. Nevertheless, we need to watch it carefully for signs of further support. It will be interesting to see if this level holds in the coming days. We have a market which is short-term bearish but has some good supports, although one very strong one has broken.
The general expectation is that inflation will peak sometime in H2 but we have to be cautious of that view changing as it will have a significant impact on the market. Money market rates are starting to show a worrying uptrend and if the view shifts that the inflation peak is further out, the market will get more negative.
It’s interesting that on Wednesday the stock market moved higher the day following a significant monetary tightening by the Reserve Bank of India.
Was it a relief rally that the bad news was out of the way, or a market that was feeling more comfortable that a challenging problem was being dealt with? In my experience elsewhere in the world, financial markets react well to strong and decisive action by central banks and governments and punish any signs of weakness.

*Parabolic SAR (Stop and Reverse) study gives signals for going long or short. While the study, the dots, is below the price action it indicates a long position but as the trend slackens the study touches the price action and indicates a switch to a short. It is supposed to be a constant position trading system.
**Moving Average Convergence Divergence (MACD) is a type of oscillator that can measure market momentum as well as follow or indicate the trend. MACD consists of two lines, the MACD Line and the Signal Line. MACD oscillates above and below a zero line without upper and lower boundaries. Signals are generated when the MACD Line and the Signal Line cross. A buy signal is generated when the MACD Line crosses from below to above the Signal Line, the further below the zero line that this occurs the stronger the signal. A sell signal is generated when the MACD Line crosses from above to below the Signal Line, the further above the zero line that this occurs the stronger the signal.
***Alpha-Beta Trend analysis is an attempt to avoid some of the false signals associated with crossing moving averages. Three lines are plotted: Upper band, Lower band and Trading filter. Together, the upper and lower bands define the uncertainty channel for trade decisions; the width of the channel varies with volatility.
If the trading filter moves from within the bands to below the lower band, this is a signal to buy or enter a long position. If the trading filter moves from within the bands to above the upper band, this is a signal to sell or enter a short position. If the trading filter lies between the bands, no trend is indicated. An uptrend is when the trading filter is below the lower band. A downtrend is when the trading filter is above the upper band.
****The RSI is a price-following oscillator that ranges between 0 and 100. The name “Relative Strength Index” is slightly misleading, as the RSI does not compare the relative strength of two instruments, but rather the internal strength of a single instrument. Because you can vary the number of time periods in the RSI calculation, you may want to experiment to find the period that works best for you. (The fewer days used to calculate the RSI, the more volatile the indicator.)
An overbought or oversold market is one where prices have risen or fallen too far and are therefore likely to retrace. If the RSI is above 70 then the market is considered to be overbought, and an RSI value below 30 indicates that the market is oversold. 80 and 20 can also be used to indicate overbought and oversold levels.

The 200-day Moving Average lent some support on Tuesday with the close near the line.

The drift lower saw the RSI come back at bit to just below the key 70 level. This could be the start of a reaction low I was talking about on Monday - see below.

Otherwise technical signals like the MACD and Parabolic-SAR are still near-term bullish. (See the middle chart for their initial signal where I have marked where the MACD cross coincides with the Parabolic-SAR switching to indicate a long position)

We need to watch both these studies carefully as the bullish signal could change.

The recovery has so far been very similar to what we saw after the sell-off in 2006 with a slight overshoot to the downside below the longer trend. We are now back above our long term trendline and current end-year forecasts of around 19,000 look reasonable as you can see from the lower chart. One thing to watch for is a minor downward correction to the recent upturn to form a ‘reaction low.’

Have a close look at the 2006 downturn and you will see what I mean. From a technical point of view don’t be surprised to see the BSE correct back towards the long term trendline for a short time.

All that has really happened is that the BSE has corrected from the extremely overbought levels seen late last year. Since last November the chart had been pointing to a correction such as the one we have seen, as regular readers of this item will know.

Please note the 200-day on this weekly chart is calculated week-to-day so the absolute level of the line does not exactly coincide with the value on the daily chart - for our purposes it is close enough)

(Parabolic SAR (Stop and Reverse) study gives signals for going long or short. While the study, the dots, is below the price action it indicates a long position but as the trend slackens the study touches the price action and indicates a switch to a short. It is supposed to be a constant position trading system.)

Below is a picture of the BSE valuation vis-à-vis the main Asian markets since the start of the year and since the longer-term upmove started in May 2005. As you can see the BSE is underperforming its Asian countrparts so far this year but measured since May 2005 it is still outperforming.