Market Indicators To Read Market Trends

Timing the markets, it is said, is almost impossible in the long term. However, there are very many traders and investors who keep persisting on doing so. A few succeed while a majority don’t. Geyatee Deshpande shares her perspective on market timing and highlights several indicators that can be used to identify market trends that can help time the markets 

It is believed that in the short term the markets are irrational. And the market trends in the short term reflect the same irrationality and capture investors’ and traders’ reactionary behaviour to the stock prices. Since a majority of investors and traders react emotionally to short-term trends in the market, it is commonly seen that the trend over the short term is often extended with an increasing number of investors jumping into the broader market trend. It soon turns into a frenetic scenario and the market gets overextended with increasing participation. Such overextension of an existing trend is what investors – both in the long term and short term – have to watch out for. 

Any ability to recognise such consistently overbought and oversold situations can immensely help investors lock in profits and, most importantly, avoid huge losses. Indeed, timing the markets has the unique potential to magnify the returns. The question is how best to time the markets and whether it is possible at all to time the markets. Often grave investment errors are made in pursuit of indulging in such an exercise. As long-term active investor Subramaniam Swamy puts it, “I have always believed in timing the market and often enough I am successful at buying low and selling at higher prices. However, when I study my own performance it looks like I would have made more money if I had remained invested rather than engaging in active trading.”

“For example,” he continues, “recently I bought Tata Motors’ shares at Rs 75 per share and managed to sell it at Rs 140 per share. I was truly impressed with the returns I made in a short period of time. However, Tata Motors is now trading at more than Rs 300 per share. I followed some technical indicators which suggested at that time that Tata Motors was in the overbought zone. I had a similar experience with Tata Elxsi. After purchasing it forRs 990 per share, the stock is continuing to gain ground even as some of the technical indicators suggest it is in an overbought zone.”

Kanika Agarrwal,
CIO and Co-Founder, Upside AI

"Market Levels Should Not Matter"

I read a statistic recently that interested me: the Sensex has grown by about 12 per cent annually over the last 23 years. If you missed every year’s top 2-3 days of trading, your return would be approximately negative 1 per cent. So the question is how will you know when those best days of the market are? The short answer is that you cannot. Since we are all playing for the upside in the market and equity returns are lumpy, it is far more important for us not to miss the rallies than it is to try and avoid a dip by timing the market. 

We as investors must realise that the market is always ‘about to correct’. The issue is when is it about to correct since it can be one month or one year and what does the ‘market’ define. If you are buying mutual funds or ETFs which have a broad basket of stocks, you should index over time and must ride the corrections if you want to see the good days. On the flip side, if you are using a bottom-up approach to pick stocks, the market levels are irrelevant and you should only care about the value versus the price arbitrage of your stock picks.

We have in the past also reached historic Sensex levels of 20,000, 30,000 and 40,000 and we are now at 50,000. So if you asked yourself the same question in the past, you would have missed the good days of the journey to 50,000. Will we go to 1,00,000? In all likelihood, yes! The main issue is that no one knows how long the journey will take or the bumps in the road. Therefore, our suggestion is to spend as much time in the market as possible to increase your odds of riding the good days – invest systematically and market levels should not matter. 

“In my experience it is crucial to first identify your portfolio stocks – stocks that you do not want to sell. However, we keep looking for opportunities to buy on dips and trading bets. Market timing skills can be applied for both these kinds of investments,” he adds. While identifying a market trend may not be that difficult these days with the help of several indicators, one has to simply watch out for the overextension of the existing market trend in order to protect profits and avoid probable huge losses. Often the momentum in stock prices leads to continuation in the market trend which usually pushes stock prices away from the equilibrium level.

One has to judge how far the stock prices have moved from the equilibrium level and that may not always be an easy task, even for experts. Looking at the historical data it is observed that whenever the stock prices have shot up too high the crash in stock prices has also been steep and rapid. Similarly, whenever the stock prices have fallen too much beyond the equilibrium level the bounce-back is usually very sharp and ferocious. The recent instance of the crash in stock prices due to the pandemicled lockdown is a point in case. Most of the savvy investors who are well-versed with the technical aspects of the market are able to read the catalysts realistically and thus are in a position to exit markets before the crash and are also able to buy stocks closer to the bottom levels using certain market indicators. 

Apart from the knowledge of technical analysis that can come really handy for investors and traders, following are some of the other indicators that can help ascertain the market trend:

1. Heightened Speculation : An investor has to ascertain if there is rampant speculation happening in a similar direction. 

When there are enough signs of rampant speculation it is good enough to determine that the trend may reverse soon. How soon is extremely difficult to predict. Heightened speculation in a bull market ensures that a positive feedback loop is prevalent in the market, which pushes the stock prices higher. This leads to stock prices dragging themselves away from their intrinsic value. It thereby creates a bubble, as a result of which the risk of portfolio losses gets magnified. It is important to identify market bubbles and look at various indicators that provide any such hint. Sans market correction at regular intervals, the bubble gets bigger and with continued rise in prices the risk of market crash amplifies. 

2. Fundamentals and Valuations : If there is some sort of frenzy pushing the stock prices which is not backed by matching economic conditions and macroeconomic indicators, there are chances that the stock prices will correct and crash. One has to keep a tab on GDP growth data and also on the valuations. If the stock prices are trading at double the trade multiples of their long-term averages, one must be alarmed. However, while doing so, the rate of interest also needs to be discounted. These days the rate of interest is at historical lows and may push valuations higher. By correlating the fundamentals, peak valuations and stock prices one may be able to predict a market crash or an overbought situation. 

3. Volatility Index : Tracking the volatility index such as VIX can prove to be extremely profitable if done on a consistent basis. The VIX is a real-time market index that represents markets expectations for volatility in the coming 30 days. Often savvy investors and traders use VIX to measure the level of risk, fear and stress in the market before making any investment decision. Extremely low level reading of the VIX may indicate complacency in the market while extremely high reading of VIX indicates that fear has reached its zenith. Such extreme readings in the VIX level indicate a change in trend and may help investors either make handsome profits or avoid huge losses.

4. Put Call Ratio : It is very important for any investor to understand the derivatives data as it can help ascertain the market direction. Put call ratio also known as PCR ratio is one of the most widely used derivatives data to ascertain the market moods. PCR measures the ratio of the put open interest on a given day to the call option open interest on the same day. A ratio of more than 1 is considered as a bearish signal while a ratio close to 0.60 is considered a bullish signal. A ratio of more than 1 signifies that an increasing number of investors are buying put options while a ratio closer to 0.60 signifies that a large number of investors are buying the call option. It is also advisable to use the PCR measure along with implied volatility (IV). Rising PCR and increasing IV suggest that the put activity is increasing with a heightened sense of risk.

This should indicate that the bears are in control or that the markets are bearish. Similarly, if the PCR increases with a decrease in IV, it suggests that the put activity is increasing with falling risk intensity. It also indicates that there is more writing of puts and this is a mildly bullish signal. To hunt for bottoming out opportunities, one should look at decreasing PCR with decreasing IV. It indicates the unwinding of puts and signals that the markets could be bottoming out. In another situation where the PCR decreases with an increase in IV, the implication is that the puts are just being covered and the markets may fall once again.

Conclusion

It is a known fact that market timing is not possible at all times, but if one puts efforts in the right direction, market timing can help improve the overall performance of the portfolio. The indicators mentioned in the article can be effectively used to ascertain the market direction and necessary decisions can then be taken to adjust the portfolio and protect portfolio returns. Where most of the investors and traders go wrong is in failing to read the market indicators accurately. They also fail to comprehend the market trend and hence in the long run it is perceived that market timing is impossible.

To increase the odds of winning investors simply have to spend as much time as possible in the market, attempting to buy quality stocks using a bottoms-up approach and hold them for the long term. The process of active portfolio management involves identifying value in quality stocks and hunting for bargains. Here is where using market indicators can be very useful. One can focus on oversold stocks in a bearish market hoping for a trend reversal. Knowing market indicators and using them profitably can come handy but overusing them and misinterpreting the market indicators can lead to huge losses. The trick is to make market indicators your true friend by using them deftly.