Bears to stay in control in 2011

The breaching of the 200-day exponential moving average confirms a downtrend and a long-term bear market ahead.

The technical signals since mid-January have been very clear. The market has shown a downtrend and it looks very much like a long-term bear market. The prospects for 2011 are, therefore, not good.

Look at the long-term trend of the Nifty mapped across its own 200-day exponential moving average (EMA). One confirmation of a bear-market is the price falling below the 200 EMA. This happened on January 25, 2011, and it was a decisive penetration. The last time this happened, in January 2008, prices dropped over 60 per cent from the all-time peak of 6,257, before they bottomed in October 2008. Indian bear markets have a history of big corrections of at least 50 per cent.

In the immediate future, we see the ongoing rally continuing until around Budget. There is resistance at the EMA levels of 5,600-5,650. If that is broken, there is a resistance at 5,850-5,900. That is where we would expect the rally (technically an intermediate correction in a big bear market) to end.

Recovery signals
One sign that the market may recover quickly would be a climb past the 2011 peak of 6,180. If the market closes above 6,200 for 2-3 sessions in succession, the outlook becomes much more positive. This is unlikely; we would expect an abort at 5,850-5,900, followed by a drop below EMA. If the Nifty does climb above 6,200 and sustains there, consider this fall a “bear trap” and go long again. It would take an extraordinary Budget, and strong institutional support, as well as a sharp fall in inflation, to create the necessary sentiment.

The downside levels

On the down side, there are supports at three key zones, which position and long-term traders should watch. Even if these supports are successively busted, each zone will provide support for at least a temporary relief rally. The first zone is 4,900-5,000, the second 4,400-4,500 and the third around 4,000. As of now, the 2011 low is 5,175 – almost touching the first zone anyhow. We would expect the area between 4,500 and 5,000 to be traded extensively before the year is out.

In early January, this writer was markedly cautious in warning that the market looked nervous. Those bearish signs have been confirmed and, in the face of poor technical signals and gloomy sentiment, it would be foolish to stay on the long side.

Traders should go short
Any trend-following trader should aim to stay short as far as possible, in sync with the long-term trend. Giving due importance to the Budget, one should probably wait for this specific rally to terminate before going short. That means, watching for successively lower tops and a confirmatory signal like a fall below 5,175. Use a combination like a 20-Day EMA versus 55-Day EMA for the trigger signals. This has a historical pattern of picking up significant intermediate moves.

Expensive for value investors
For a value investor, the equation is difsferent. The Nifty currently has an average price to earnings ratio (P/E) of around 20. The long-term average PE is close to 17. Ideally a value player would like the PE to be pushed down till 15 or lower before taking broadly diversified equity exposure. (It bottomed just below 11 in October 2008.) Roughly that means waiting for a 12-15 per cent pullback till somewhere between 4,500 and 5,000. Below 4,500, the equation for a value investor becomes very attractive.

The author is a technical and equity analyst