Ways To Identify Market Peaks

With the Indian equity markets hitting all-time highs and outperforming the global peers, investors and traders are concerned about whether the markets are peaking. Yogesh Supekar explains the multiple factors influencing the market moods while Karan Bhojwani highlights the several indicators one should use to identify the peaking curve of the market

The Indian equity market is proving to be a shining star on the global stage with the BSE Sensex and Nifty 50 continuing to hit record highs in 2021. So far in 2021, the Indian frontline indices are turning out to be world-beating indices with Nifty 50 up by more than 25 per cent and BSE Sensex trading higher by more than 23 per cent. Amongst the major emerging markets, Vietnam is the only country beating the Indian benchmark indices, soaring by more than 35 per cent. The outperformance is there for everyone to see; however, what is not clear to a majority of investors is whether this outperformance will continue in 2021 and beyond.

While no one argues about the strong structural story in India at play which promises to create wealth for entrepreneurs and companies that can get their act together, the practical question that every investor today is asking is: Haven’t the markets run up a lot and aren’t they trading way ahead of the fundamentals? Going by the textbook definition and every theory in finance that talks about valuations and extremes in the equity markets, in all probability the Indian equity markets are very close to being in an extreme situation where we can say that the markets are a little more than overvalued and could be close to a bubble-like situation.

Now, the curiosity is how long can the markets stay like this? And further, how long can the markets stay overvalued and yet not be in a bubble zone? Unfortunately, there is no device or an indicator designed to calculate and quantify the answer for us. However, we can at best, make an educated guess on such contradictory and yet meaningful aspects of the market. Experts who have been tracking the markets can confirm that they do have a tendency to remain overvalued for a frustrating long period of time, so much so that people start accepting the new ‘high valuation’ as ‘normal valuation’.

We also hear from several experts that you cannot compare the valuation of a high-growth company equipped with the latest gadgets that can be used to reach out to millions of customers within a matter of seconds and which also can borrow money at nominal interest rates to the age-old company toothless without the advantage of today’s technology and that used to borrow money at astronomical interest rates. This argument is often used by several analysts and bulls in the market to justify high equity valuations in today’s world.

Says Chandrakant Munot, an investor in equity markets, “I don’t have to explain how strong the market momentum is right now. It’s been almost a month that I have liquidated my portfolio and parked my monies into gold and some of it in fixed income securities. My thesis was that the equity markets will correct if not crash. With an intention to preserve my capital and to retain by huge profits, percentage-wise, that I made in the equity markets over the past 18 odd months I thought I should switch to a different asset class. Obviously I was wrong and after I sold my portfolio it is up by over 10 odd percent in just 23+ trading sessions. Ever since I liquidated my portfolio, I have been hunting to find an expert view or an opinion to confirm my logic and expectation on market correction or even better a crash.”

“I did find some experts who think there might be a correction and that the current market is highly overvalued but the prices are not falling as per my expectation. There must be some way to identify when the markets are going to change the trend. There must be some way to identify if the markets have peaked or have topped out. Over so many years in the market, I have overlooked the importance of identifying trend reversals. Not anymore, because I have realised that it is crucial to identify a market peak as it is to identify a market bottom,” he adds.

Indeed, identifying a market peak can be a profitable exercise. However, it is not always possible to identify the market tops accurately. That said, one can always be cautious when the markets are overvalued or overbought or both. One gets a fairly good idea when the markets are overbought and overvalued at the same time. When it comes to identifying a market peak, support of technical analysis is required. Technical analysis helps us identify the early warning signs of a market peak.

The Red Flags

It is said that certain clothes are associated with certain types of weather, as for example, if it’s the summer season, cotton clothes are more preferable. In the same way, certain chart formations are often associated with certain market phases. Generally, we assess the movement of the security in four phases:
1. Accumulation
2. Mark-Up
3. Distribution
4. Mark-Down.

Since we are talking about identifying the market peaks, the third stage i.e. the distribution phase would be of our point of discussion.

Narendra Solanki

Head - Equity Research (Fundamental), Anand Rathi Shares & Stock Brokers
"No major shock could take the Indian market by surprise"

What is your outlook on markets right now?
Overall, the markets are positive on the back of better latest quarterly results, positive domestic macro outlook, stable global macro and decreasing probability of the third wave in India as vaccinations increase. However, from valuations, perspective markets have pretty much priced in these factors so not much room for significant upside till the next round of results, but no major risk is visible either for large draw-downs.

Will small caps and midcaps continue to outperform?
The domestic economy is placed in a growing trajectory so naturally companies should also do well. Instead of clubbing all the companies in a broad category, I would like to add that all companies posting good growth and financial internals should continue to do well.

What are the key risks for markets at this juncture?
There are low risks as far as domestic factors are concerned except concerns around the third covid wave which is also going down as vaccinations increase. Currently, any major shock or risk which could take the market by surprise might come from global factors.

Are we at 'peak' right now?
Peaks and troughs are very difficult to predict, and in my view, and we should refrain from taking such risks. However, what we see is that as long as the economy and companies continue to grow there should not be any concerns regarding where markets are going. Also, short term money flows do impact markets and any shifts due to global factors in these flows do affect in the near term. Regardless, we should continue to have good companies in our portfolio and as long as they deliver on their performances.

As is well-known, the markets spend most of their time in a trading range and these ranges which develop over a period of time may have three main interests behind them: it is accumulating and creating a foundation for an upward movement or it is distributing in developing a foundation for a downward movement or it is fluctuating up and down random-ly without any distinct intent. So, when this range develops, how would one distinguish which of the interests out of the three is at play?

Here are the important pointers which would help us to identify the distribution phase:
• Red Candles Compared to Green Candles: After a strong up-move i.e. impulse move on the upside, it would enter into a range phase and during this range phase, look at the count of green and red candles. If the red candles are far greater in number than the green candles, this would be the first hint that a distribution is going on. The higher the count of red candles compared to the green candles, the higher the signs of caution.
• Range of Red Candles: Once it’s established that there are a greater number of red candles compared to the green candles, one should look out for the range of red candles. Usually during the topping out phase, the range of red candles is greater than that of 10 days’ average range. As the number of red candles with higher than 10 days’ average start to show up frequently, it’s time to be cautious.
• Closing of the Day: As the saying goes, the amateurs control the opening and professionals control the closing. When the start of the day is in green and the close of the day is at an opposite extreme and near the day’s low then it clearly states that the big participants are in a distribution mood. And if this occurs frequently, it’s a red flag. 

Stalling Day Signal & Market Peak

Understanding when the market has reached its peak is crucial for investors as market timing can protect profits for investors and traders alike. Stalling in simple terms is a form of distribution signal that help investors and traders to understand if the market can get bearish. In terms of reading the market, stalling days are the days when there are heavy volumes without much progress in the price.

A stalling signal can be identified when the index jumps higher, but gives up most of its gains and manages to close in the lower half of the day’s price range. It is referred to as stalling signal because the index stall’s out.

Identifying the stalling signal is not easy as certain conditions need to fulfil to confirm, such as the index must not rise above 0.4 per cent and the volume must be higher than the prior day. One of the most important prerequisites is that the index must be at all-time highs.

Investors and traders can easily get confused as during the stalling days the index actually gains and yet it can tell you the market is getting bearish. However, savvy investors and traders would notice heavy institutional selling behind the curbing price gains. The institutions are selling into the stock market strength and this event is captured by smart observers if a stalling signal is identified. The stalling days are a subtle type of distribution signal, however, the markets do not decline.

What is a Stock Market Bubble?

A stock market bubble occurs when the share price rises significantly without a parallel surge in the valuations of the underlying company. The stock price exceeds the company’s fundamental value by a sizeable margin. The bubble is typically driven by raw speculation and stock prices are not supported by the company's profitability and future prospects.

Alan Greenspan, Former Chair of Federal Reserve, popularized the phrase ‘Irrational Exuberance’ to express the collective optimism amidst traders and investors that often causes an exponential rally in share prices that outpace the underlying fundamentals of the companies. The general cause of a market bubble includes low-interest rates, high liquidity, a conducive economic environment, heavy inflow of foreign funds, burgeoning overall demand and investor frenzy. While the term bubble is most frequently associated with stocks, speculative bubbles can occur across a diverse range of asset classes, including fixed income securities, real estate, commodities and even cryptocurrencies.

When a stock market bubble bursts, shares prices fall dramati-cally as there is panic selling by market participants. There can be various causes for the bubble burst such as a big group of shareholders booking profits, a downgrade in rating or a promi-nent investor exiting their position. The effect of the burst could be widespread, leading to a correction, a general economic recession or even depression. Other times, if the burst happens in a particular sector, the effect would be relatively small and short-lived.

The dot-com bubble is a notable example. The rise of the internet in the late 1990s saw an enormous number of internet-focused companies filing for initial public offerings (IPOs) in the US markets. The frenzy of investing in such companies spread like wildfire. The booming sector witnessed soaring amounts of investment, even into loss-making companies with unsustainable business models. The bubble ballooned to such an extent that S&P 500 doubled in value. Eventually, the markets peaked out and a sell-off occurred in March 2000 marked the end of the dot-com bubble. The recession that followed was relatively shallow for the overall economy but proved to be devastating for the nascent tech industry. A plethora of internet companies became worthless when the dot-com bubble burst, destroying ginormous amounts of investor wealth. 

One of the early signs of a potential bubble is the many-fold increase in the share price without the obvious triggers such as revenue or earnings growth or improvement in fundamentals. 

" Stock market bubbles don't grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception. "
-- George Soros

The distribution phase chart patterns involve the following patterns:
• Double top
• Triple top
• Head and shoulders top
• Rectangular flat top
• Rounding top
• Island reversal.

Conclusion

The foundation for the equity markets has always been earnings, valuations and fundamentals. When the earnings’ growth is superlative, valuations attractive and the fundamen-tals in place we have a very strong bull case on our hands. When any single factor of these three factors is weak, we can expect at best a market correction or a dip. And that is why we say ‘buy on dips’ can work best in bull markets. For the markets to crash we will need to see all the three factors weakening i.e. earnings drying up, fundamentals weakening and valuations extremely unsustainable. That clearly is not the case right now. There is no arguing the fact that the valuations are high by historical standards.

But again, high valuation is a relative concept and for some growth investors the high valuations may not be as high to call for a liquidation of the portfolio or to short the markets. Only high valuation in markets with fundamentals intact and earnings’ growth in place may push the markets lower but may not be good enough a reason for a market crash where we enter bear territory. For the markets to enter a bear territory it will have to fall by 20 per cent or so from its highs. Corporate India so far has shown tremendous resilience and flexibility. Cost-cutting measures have led to efficiencies in profit margins and the balance-sheet for most large companies, allowing them to cash in on the opportunities that the pandemic-led pent-up demand has generated.

The market is banking on strong fundamentals which in turn depend on the economic recovery and expansionary policies. The government’s recent expansionary decision be it announcement of the PLI scheme or tax incentives linked to Cover Story exports is a boon not only for the capital goods’ sector and the manufacturing sector but also the service sector. The new dynamics in the market asks of investors to judge it not based on the trailing PE ratio but on the forward basis. If we consider the PE multiple for the markets, a forward looking one, the valuation suddenly does not look ‘high’ and looks ‘reason-able’. The government’s focus on exports and the growth in exports is comforting for foreign investors. In fact, foreign investors’ confidence is crucial for a capital-starved nation like India. With exports rising, the private sector is also likely to participate in the capex cycle which in turn will create huge economic growth opportunities as an invisible hand will be at play.

Bulls in India can also take comfort from the aggressive vaccination drive, now being touted as one of the biggest and the best in the world. This is important because at this point of time it is the Delta variant and the possibility of a third wave which pose the biggest risk to the markets than any other factor. The ‘taper talk’ is amongst the top worrying factor for the market momentum; however, the market has been preparing for it. The credit spreads the difference between corporate debts and the treasury yields have not widened, suggesting that the market does not think there is a balance-sheet risk in the US’ markets at least. In India the forming of the ‘bad bank’ will be one of the biggest triggers that the bulls would have expected for the banking sector.

The banking stocks’ participation is crucial for the bull story to remain durable in India. Banking is central to the India growth story. What the bad bank decision does is put the largest lenders in India on a growth trajectory after cleaning their balance-sheets. This will allow easy credit access and most importantly many of the PSU lenders will start making some money for themselves. The fundamentals in the long run always prevail and remain measurable and key to investment deci-sions, no matter how much one may say the market is in the hands of novice investors driven by meme stocks that don’t understand fundamentals. Fundamentals will always dictate the market in the long run and it is only wise to buy quality stocks with strong fundamentals.

That said, peaks in the markets are also natural and inevitable. However, it is not necessary that a peak in the equity market suggests a cycle’s end. If the earnings’ outlook is positive and the fundamentals intact, long-term investors can adopt a ‘buy on dip’ strategy. However, if the earnings’ growth is expected to evaporate and fundamentals to deteriorate, we have a problem at our hand since a deeper market correction or a crash cannot be ruled out. As of now our verdict is strong earnings’ outlook, strong fundamentals and high equity valuations. One can focus on the market indicators we discussed in this article to identify a potential market trend reversal and to ascertain a potential market peak.