What the charts foretell

YEAR OF THE BULL Milind Karandikar Neowave Analyst 2006 was a good year for stock market investors, with key indices shattering several psychological barriers. Will 2007 be similar? In this article, The Smart Investor gets four technical analysts to predict what the markets will do this year.

While one of them is a gung-ho bull, the other three advise investors to tread cautiously. In terms of stocks, there seems to be a bias towards mid- and small-caps, and sectors that have not participated in the rally last year.

In my previous article in The Smart Investor dated October 23, 2006, I had mentioned that many investors were experiencing a fear of heights in the current bull run in the Indian stock markets. That same nervousness continues to prevail with the markets scaling new peaks.

This indicates that our markets are nowhere close to any major top. Those who have missed the boat have been expecting a sharp correction since long. But the market is supreme and doesn’t listen to anybody’s wishes. It is time to come out of this wishful thinking and look for new buying opportunities in this strong bull market.

In this article, I am presenting an alternate possible pattern developing in the position of X-wave mentioned in my last article. Earlier I was interpreting the X-wave to be a diametric formation carrying seven legs. The swift price action that was expected in last two months has not materialised and forced me to look for a different interpretation.

The BSE Sensex monthly and weekly charts show this entire rally from May 2003 to be zigzag that has three legs (a), (b) and (c). Wave (c) has subdivided into five parts labelled 1, 2, 3, 4 and 5. We are probably in the last part ie wave 5 of wave (c). Since waves 2 and 4 are overlapping, wave (c) has to be interpreted as a terminal impulse pattern within which wave 5 will be the longest wave.

According to Neowave theory, this wave 5 will usually cover 100 per cent to 161.8 per cent of the price action of waves 1 and 3 combined. On a logarithmic scale this calculation sets a target of 20,000-plus for the Sensex. And that could happen in the year 2007 itself.

The most optimistic forecasts by many analysts, for the year 2007, are not exceeding 16000. But that is what Neowave theory is all about. The predictions are based on certain rules and not on my personal desire.

Of course, the future course of the markets would resolve the validity of my pattern interpretation. But if it is right, then there is a great buying opportunity even today.

Many stocks in the small and mid-cap segments seem to be in a huge accumulation phase and are likely to give an upward break-out. Once such breakouts are confirmed one can buy these stocks on declines that follow the swift rallies and hold for at least 8-12 months.

Those who cannot overcome the general feeling of nervousness would miss a lifetime investment opportunity that year 2007 presents. My advice to small investors is to overcome this fear of heights and invest. They should take this opportunity; else the other wise men will take it away.

BE CONSERVATIVE Mukul Pal CEO, Or-phe-us Capitals The Indian economic cycle is heading to the late expansion stage. Theoretically, there are five stages viz. early expansion, middle expansion, late expansion, early contraction and late contraction.

The very fact that we are heading to the late expansion stage suggests that we are still away from a top and 2007 might see a new high above Sensex 14,000 points before the real slowdown starts.

We at Or-phe-us still see the immediate preferred direction sideways to down with a potential upward break-out probably after the March 2007 quarter. We had highlighted broad market divergence in November 2006, which still stand firm.

Barring Sensex, BSE Bankex, CNX IT and BSE Capital Goods Index, and the other indices (Healthcare, Small-Cap, Mid-Cap, BSE Oil, BSE FMCG, BSE PSU, BSE Auto) are still below May 2006 lows.

Historically, such divergences do not guarantee that markets may turn down or remain sideways, but if you look at it from the inter-market perspectives and add in a few technical aspects, we have enough reasons to validate our case.

The capital goods sector has exhibited a clear leadership since 2004 with average returns over the last three years near 80 per cent. This was the only sector to churn up more than 100 per cent ever in a year.

Capital goods, representing the industrial sector growth, marks the best run of the economic cycle. Materials and energy sector should assume leadership from current levels. And the effects should be visible starting this month.

Materials and energy: Though we are still negative on zinc and other base metals on the intermediate term, the materials sector (chemicals, construction materials, glass, paper, forest products, metals) is a mixed bag, and steel and aluminium still seem to have upside left. Integrated aluminium companies are still trended up.

On the energy front, we do not see oil falling substantially below $50. After oil hits a base, the respective sectors should assume leadership. Till then we can see some negativity in both the energy and materials sector. Energy is also a late expansion sector and seems in sync with our preferred wave count on market.

BSE Bankex was the next best performing index after capital goods sector. Credit expansion is the highest in late expansion stage.

This boosts banking profitability on one side and makes banking sector very vulnerable to corrections. We are near our price targets on the sector and sector components and recommend pre-Budget reductions on the sector.

Technology: Despite the noise that Indian tech companies generate abroad, the sector has under-performed every other sector in 2006. This under-performance should continue.

Technology is in a middle expansion sector and does not do well in late expansion sectors (current). We still believe the technology sector prices should correct sizeably from current levels. We will not be surprised if technology gives negative returns in 2007.

The automobile sector should see negative surprises. The index and its constituent stocks should decline further from here. This push and pull of various sectors should result in sideways to net negative movement till the first quarter of 2007.

Banks and technology alone cannot sustain the markets at current levels. And with the capital goods story being more than three years old, we need smart sector allocations as we head into late expansion. Energy and materials should start ticking from this quarter. Let's be conservative in 2007.

CORRECTION AFTER THE MARCH QUARTER Devangshu Datta Technical Analyst Since April 2003, the Nifty has climbed some 324 per cent. Despite several corrections, and the sheer unlikely length of the bull run, the upwards trend has got even steeper since April 2005.

By definition, any long-term bull run should lead to new record highs. But the Indian market has never before seen a rally of this length or recorded this type of sequence of successive highs for months on end. By definition, there's been a paradigm shift in the market--this mirrors a broader situation where GDP growth has been excellent for a four-year period.

Can this bull market last through 2007 or is it time for a big correction? Well, since May 2005, the Nifty has risen along a steep 50 degree trendline (monthly charts). Volumes have been good and other breadth signals have not been particularly negative. At first glance, there's no reason why the bull run cannot continue indefinitely.

There are some signs of a possible market top. Despite generating good volumes, the Nifty hasn't been able to break decisively past the 4000-point level. There's a very strong resistance above 4000.

Momentum signals such as the RoC have been weak for several months now–that's a negative divergence. Intra-day volatility has also been low--this is usually a sign of a nearing top. Advances have frequently been outnumbered by declines--another warning signal.

Nevertheless, one of the oldest rules of technical analysis is not to bet against an existing trend until and unless the price line confirms indicator divergences.

It's perfectly possible for a price line to continue rising even if there are negative divergences. We cannot trade in the hope of a correction until such time as the price line reacts and confirms divergence.

I do think that a major correction sometime in 2007 is extremely likely. We may see a repeat of the situation that occurred in May-July 2006. The market dropped by 30 per cent before it made a recovery. If such a deep correction occurs, it will have one of the following potential fundamental triggers:

Interest rates are getting tighter – that automatically makes a correction more likely. Another rate hike in the next RBI review could trigger a sell-off. The Budget could fail to satisfy the market which is, as usual, making miraculously optimistic consensus estimates about reform possibilities. There may be some global event that adversely impacts all stock markets and leads to an FII pull-out. (The foreigners have been strong buyers in the first week of 2007). The current highly optimistic earnings estimates for 2006-07 and 2007-08 may not be met if there's even a minor dip in economic demand

In technical terms, there are three possibilities – the obvious one is that market will continue to run up.

This would involve breaking the Nifty 4000 resistance and continuing to ascend along the steep trend line that is being maintained (this is incidentally nearly coincident with the 10 month/200-day moving average on monthly and daily time frames respectively). We do have target projections in the range of 4150-4200 on the chart patterns and these could be exceeded if the market crosses 4000 with volume expansion.

The second possibility is that the 4000 resistance will hold. But the market will find support somewhere around 3600 and proceed to range-trade through most of 2007 between say, the range of 3600-4100.

The third possibility is a large collapse, which will drive the market down below the 3000 mark. Even then, the overall trend would be reckoned positive unless the lows of June 2006 (2600-levels) were broken. The market has successive support levels at 3750, 3600 and 3500 in case of serious corrections.

Short-term traders should watch the 10-DMA closely. The first danger signal of a short-term correction will be the piercing of this support line.

They should also watch for situations where the put-call ratio of open interest in the near-term Nifty drops below 1.1 or rises above 2. Below 1.1, it is very likely to signal an overbought market while ratios of above 2 are also very likely to be unsustainable. The third signal to watch for is a time-period where the domestic mutual funds and the FIIs simultaneously turn sellers.

My prognosis would be that volumes are very likely to expand until the Budget is announced. That in turn, means that the intermediate trend would stay positive until late February. If the Budget is acceptable, that would be great. I would expect a correction, and a deep one at that sometime in 2007. But it's not likely to occur until March and maybe even later.

WHERE TO INVEST AND WHEN? Rajat K Bose Technical Analyst Are we headed for another year of stellar performance by the equity markets? But isn’t valuation a point of concern? What if interest rates spike further? If the global economy were to show some signs of cooling off then how would our market fare? These are some of the questions that keep haunting the minds of Indian investors now.

However, the moot question is where to put our money and when. Before we move in to specifics of sectors that look attractive, let’s put things in perspective so that we can come up with some low risk ideas.

This current bull run is already nearly four years old. Getting popular large-cap stocks at cheap valuations is a tall order. We should rather look forward to the broader universe of mid- and small-cap stocks and any sector that has so far been overlooked.

To answer the timing part, we need to take a cue from past instances. Since the early 1990s we have seen that except 1991 there hasn’t been a single year when the market moved up throughout the year.

Our market, as represented by the major indices, has gone up in the initial months of any year when the second half of the previous year has seen some sustained correction.

For the early months to show a good upswing, generally the market would have gone through a significant corrective swing in the last quarter or for most part of the second half of the previous year.

On the other hand, if the market showed a heady upswing lasting for several months starting any time between May and July we observe marked volatility and a protracted downswing during the first quarter of the very next year.

While our data, in this case, is limited to the last sixteen years beginning 1991, is not really a statistically significant population, it does throw some pointers. Going by this trend, we are likely to see a lot of volatility and a probable downward bias during the first three or four months of 2007. This seems highly probable given the meteoric rise of our market in the last six months or so, after the sharp downswing in the middle of 2006.

The scenario may not pan out only if the current surge of liquidity continues just as it has for last several months. However, it seems somewhat unlikely that the deluge of liquidity is going to continue if the allocations to India by some prominent global investors are any indication.

Thus, if the above scenario really gets repeated this time around, we might get better opportunities to invest a few months later.

One thing needs to be mentioned here, while the market participants may be obsessed with the Union Budget, it has not produced any lasting upswing except for 1991. Even the “pathbreaking” 1997 Budget saw market peaking out in less than a week’s time after its publication. Normally, Budget causes a lot of volatility rather than any sustained directional swings.

Any study done on the basis of the major indices of our market is likely to miss out some reality on the broader universe of stocks. While bull and bear swings in large-cap popular stocks continue to happen periodically with some cyclical regularity; the mid- and small-cap universe does not exactly replicate the same behaviour.

When the surge happens in them, in any particular year, they tend to show parabolic upswings only to taper off equally sharply ending in a stupor that may last for anything between two to four years.

For instance, the broad market upswing in mid- and small-caps came to an end in October 2005. This reality is corroborated by the large multitude of investors but may not be so apparent when you look at the so called mid- and small-cap indices.

Another feature of our current bull market is to take on fancy for different sectors and/or industries in different years. We initially saw a craze for retail stocks in 2003-04 while the next year it was the surge in commodities and capital goods stocks, which shifted to realty and construction last year. Expecting an encore would most likely lead to disappointments.

Thus, it makes sense to look at stocks belonging to sectors that have not been fancied like consumer durables, pharmaceuticals, paper, energy-related sectors (except power equipment manufacturers).

Most of the stocks belonging to these sectors are either at the bottom or have been range-bound for a considerably long length of time. Some of them are really good businesses with good earnings potential.

Some of these stocks are also showing accumulation signs over the last few months. These stocks could probably turn out to be low-risk decent-return bets for 2007. However, they may test your patience before they produce any good gains for you.