Indicators that could signal a major reversal are visible

We've seen a pattern through 2013 where the Nifty has periodically dipped and then recovered to rise to new levels after some weeks. This pattern has been associated with three things — one is ebb and flow of foreign institutional investor (FII) investment, the second is currency weakness and the third is political uncertainty.

When the FIIs have been selling and political uncertainty has been high, the market has fallen. When the FIIs have become net buyers again and political uncertainty has receded temporarily the market has risen again. Currency weakness was visible for a specific period in July-September and it led to a lot of turmoil at the time.

It appears that the currency has stabilised for the moment at least. However, pressures from changes in FII attitudes and political uncertainty could get stronger and stronger in 2014. The US Federal Reserve may decide to taper in January, or it may continue the QE3 expansion until March 2014. As and when the tapering starts, there will be a sell-off by FIIs in most markets because they would suffer a loss of liquidity.

Political uncertainty as the general elections draw closer could also lead to more bearish sentiment. One would, therefore, look for a stock market correction some time in 2014 and such a correction could be deep if US tapering and Indian political volatility coincide.

Right now, the market is trending close to record highs and one of the principles of momentum investing is to wait for the price to confirm any underlying trends and sentiment. Until the market reverses direction, every systematic trader will stay invested with the trend. But be prepared to take drastic action as and when the price trend does reverse.

If you're looking for a major trend reversal, the classic benchmark is a long-term moving average. The 200-Day Moving Average is about eight per cent or so below the current index levels. I would say that a serious trend reversal would require something like a two-three per cent penetration of the 200-DMA to confirm. That is, about 10-11 per cent correction from current levels, to around Nifty 5,775. If the market falls that much, it could fall a great deal more.

Of course, it is entirely possible that the market will zoom to higher levels before any correction starts. If it does so, the values of the 200 DMA will also change and so will the three-per cent penetration levels. But the signals would remain the same — look for a major trend reversal to be signalled by a two per cent penetration below the 200 DMA.

This would be a long-term positional trade. The trader would be assuming that the market had turned bearish for a period of several months and hoping for a downmove of 20 per cent or more from the entry point. The 200 DMA would, again, serve as the basic benchmark for setting a stop-loss. The trader could set the stop-loss at one per cent upwards penetration of the 200 DMA.

The author is a technical and equity analyst