SHARP RISES AND SHARPER FALLS

Remember December 2013 when the benchmark index Nifty was scaling towards a mysterious level of 6,300? This stage actually turned out to be a spooky one with traders and investors getting trapped into a nightmarish experience of dealing with a market that suddenly took a deep plunge downwards. This happened not once but twice - first in the year 2008 when the Indian market saw a vicious fall of more than 50 per cent for the period January to October and then in 2010 when the crash was not as brutal as the earlier one but got limited to 25 per cent. Most of the top guns of the Indian stock market termed this a ‘peak’ in the face of certain macro economic challenges which the country had been facing such as rising inflation, current account deficit, balance of payment deterioration, slowdown in growth, etc.

There was also an opinion pool stating that the vast ocean of ‘hot money’ that has been poured into India’s market had created a massive ‘economic bubble’ and the bubble was about to burst. So this was kind of a warning of an impending stock market crash or the birth of a new bear market post 2008 along with the 2010 crash. Even with all such macro economic challenges, the Indian equity market had a golden fate as it witnessed a heroic bull run in the history of the Indian stock market, staging a smart rally of more than 35 per cent in quick succession and emerging as one of the best performing markets.

It’s poignant but time and again the majority ends up calling tops or bottoms weeks, months or years way too soon. They may get it right sooner or later but as Anna Wintour, the chief editor of of ‘American Vogue’, once said, “It’s always about timing. If it’s too soon, no one understands. If it’s too late, everyone’s forgotten.” This is true especially if you are involved in trading or investing where timing is the key element.

The purpose of this special report is to guide and assist traders and investors to recognise and trace the psychological characteristics that a market exhibits before forming a peak and then resulting in a huge collapse. It’s a fact that predicting market movement correctly is very tough even in the best of times; however, some indicators or tools, if followed and observed properly, will help to discover the unforeseen stock market collapse.

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Price to Earnings (P/E) Ratio

Many investors take into account the price to earnings ratio (P/E) ratio while taking certain decisions. According to one view, lower the P/E ratio, the better it is for investors as there are chances of higher appreciation. It’s a good indicator that helps to find the top. Over the last 10 years we have witnessed two sharp corrections as mentioned above. During both these times it was seen that the (P/E) ratio advanced above the level of 25. In January 2008 it peaked at around 28.6 and investors know what happened thereafter. Again, in October 2010 it peaked at around 25.54 and we saw a correction take place. Therefore, this indictor signals that the index is near to the peak if the P/E crosses above 25.

Dow Theory

The Dow Theory is the pioneer of what we call technical analysis. It’s important to note that while the market tends to move in a trend, it doesn’t do so in a straight line. The market will rally up to a high (peak) and then sell off to a low (swing low), but will move in one direction. An uptrend is categorized into several rallies, where each rally would have a swing high and a swing low. For a market to be considered in an uptrend, each high in the rally must reach a higher high than the previous rally’s high and each low in the rally must be higher than the previous rally’s low.

Now how does the Dow Theory help us to identify that a top has been formed with a hint of heading for correction? According to this theory, in an uptrend, prices make higher highs and higher lows. Therefore when prices fail to make higher highs or breach the previous swing lows in the uptrend, the uptrend is disturbed and we shift from an uptrend to a downtrend. This is the critical confirmation of danger. An higher time-frame like a weekly chart and monthly chart should be used to analyse the trend. As intraday and daily chart will have more noise and may give out false signals.

Advance / Decline Ratio

The advance/decline ratio shows the ratio of advancing shares to declining shares. This ratio is calculated by dividing the number of advancing shares by the number of declining shares. A prominent sign of correction is the movement of the BSE Sensex’ advance/decline ratio. When the market moves higher and the advance/decline ratio drops, it’s an indication that the market is lacking in conviction and a crash is expected in a short while. In January 2008 when the market was scaling to new highs, the advance/decline ratio stood at 0.60 with advances at 1,066 and decline at 1,772. What followed next was a brutal correction. The situation was somewhat similar in November 2010 when the market was hovering around historical highs and the advance/decline ratio dropped to 0.82. The market correction thereafter was about 25 per cent.

‘Anything That Moves’ Euphoria

It is characteristic to see a rotation of quality value stocks into laggards or junk stocks. The latter are categorised as forgotten stocks which were once the darling of investors but have now fallen by the wayside because of some corporate governance or financial issue(s). When you see such kinds of stocks moving higher like there is no tomorrow, the hint is that the market is into its last leg of up-move and nearing its top formation.

VIX - Volatility Index

The Indian Volatility Index (VIX) is a key gauge of market anticipation of near-term volatility. As we know, volatility implies the capacity to change. The volatility index tends to scale higher when the markets are highly volatile; on the other hand, the volatility index declines when the markets become less volatile and move in a stable formation. VIX is also referred to as the ‘Fear Index’ for the obvious reason that as the VIX rises, investors happen to become fearful as the markets are expected to see a big movement in either direction. Analysis indicates that a rising Indian VIX is a matter of concern since it tends to lead to a sharp correction. In other words, the volatility is higher in a falling market than in a rising market. If the volatility rises sharply, investors should take it as an early warning of a trend shifting from positive to negative.

The IPO Sponge Effect

An IPO (initial public offer) is the process of raising funds from the public for the first time in the market to expand, grow or restructure the company’s debt. In return the company allocates shares to the investors. In January 2008 there was a lot of buzz on D-Street for the largest ever IPO in the history of the Indian market by Anil Ambani-controlled Reliance Power. As many as four crore forms were distributed and the IPO received record subscription of Rs 7,50,000 crore. This IPO therefore sucked out an enormous amount of liquidity from the secondary market in hopes of huge gains in the short term. During this phase the Indian market posted a peak and then saw a sweeping collapse. History repeated itself when Coal India Limited’s IPO replaced Reliance Power as the biggest ever Indian IPO. It was announced in October 2010 and around that period the Indian stock market witnessed a peak and an immediate correction.