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Blowing off the froth - Ah it’s happened again

If you have a sense of deja-vu it’s no surprise, as history has just repeated itself. Phil Smith explains the recent market meltdown. Slideshow

business Updated: Jan 24, 2008 15:12 IST
Phil Smith

If you have a sense of deja-vu it’s no surprise, as history has just repeated itself with an overblown stock market springing back to its longer term trend.

It’s not rocket science, there is no mystery about it and you don’t have to be a financial whiz-kid to understand what’s happened. Or, come to that, to watch for signs of it happening again in the future.

Around August last year the wobble on other stock markets due to the subprime problems prompted some investment money to find a home elsewhere in the world. One of those parking lots was the buoyant India market. This caused quite a sharp acceleration of the two-and-a-half-year long up-trend the BSE has been enjoying and the market rise gathered pace.

This obviously caused much bullishness and comment that India was a great place to invest and was an irresistible magnet for foreign money but totally missed the point that nothing fundamental had changed in India to drive this new flow of cash.

Given there was no fundamental domestic reason for the inward flow of funds - there had been no change of government, the economy had not suddenly surged, fiscal or monetary policy has not changed or anything like that - this sharp acceleration of trend had to be eyed with suspicion.

When money flows into a market you have to ask why? If the fundamentals have not changed then there is a good chance the money will flow out again and the market return to its normal trend. This has been the case at least three times now for the India stock market since the rally really got going in earnest in May 2005. Each time the situation has been almost identical.

This is not 20-20 hindsight. Regular readers of our sister technical analysis Web site will have known all about this acceleration of trend and the fact that a correction was on the cards.

Take a look at Chart 1 on the slideshow. It is the BSE since the start of the rally in May 2005. The angle of this broad 2-1/2 year up-trend is evident and given current fundamentals it’s not unreasonable to expect the speed of the rally to remain fairly constant.

As you can see, whenever the market has surged away from this broader trend it has come back, most notably in Q2 2006, Q1 2007 and to a lesser extent Q3 2007.

What we saw during August 2007 to January this year was an even sharper acceleration away from the broader trend and, given fundamentals had not taken a significant shift, a return to the norm was certainly not an unreasonable thing to expect.

As you can see from the chart this latest rally from August last year was very steep indeed.

So with the intermediate trend accelerating away from the longer-trend it was time to start getting suspicious and ask why? Answer, no real reason other than a lot more foreign inflows, volumes were indeed very high, and all this was information freely available to all investors. There was no mystery about it.

So, if we were rallying away from the normal trend for no good fundamental reason there was a pretty good chance we will return to trend at some stage, right? Right.

Exactly the same thing happened in Q2 2006 as you can see on Chart 2. There was a strong acceleration of the price action away from the broader trend and there followed the sharp correction then with all the accompanying hysteria. But, no surprise, the so called ‘collapse’ was simply a move back to the old up-trend then it was business as usual.

The same thing happened, only to a much smaller extent, in Q1 2007 and Q3 2007 with a rally away from the longer trend and a correction back.

The major longer-term trendline I’ve drawn in on Charts 1 & 2 is a little subjective and for a much more accurate guide to the longer term trend you must look to the good old tried and trusted 200-day Moving Average. This is a widely used measure used to smooth out short-term fluctuations thereby highlighting longer term trends.

Have a look at Chart 3. As you can see the 200-day has been excellent support for the BSE since the rally began. Always keep an eye on it for every stock market or stock you watch. It’s an excellent indicator of the longer term trend and in most cases a very significant level when the price action touches it.

Just look at how good its support for this market has been for the past two years.

One other major thing to bear in mind when analyzing market behaviour during corrections like the ones we have seen is how far the market usually corrects. History has shown that 1/3 and 2/3 corrections, both up and down, from the major preceding price move are very much the norm so always watch for this scale of correction.

If you look at Chart 4, the correction in Q2 2006 was 2/3, the correction in Q1 2007 was 1/3 and the latest correction that has caused so much angst and wailing and gnashing of teeth is - 2/3! In other words, nothing more than a simple, albeit fairly deep, correction to an overblown market.

In fact, there is a more accurate technical measure of market retracement called Fibonacci which you will find is referred to many times on the technicals Web site.

One thing is for sure, if you see an acceleration of a market trend in higher volume you need to start thinking about what is happening and what is the underlying cause. The stock indices in India have followed similar patterns very closely during the current 2-1/2 year rally so do keep an eye on these trends on our technical analysis pages.

Always remember that markets behave the same everywhere and there is nothing new under the sun. If they go up too quickly they will correct. In the case of India it has so far been fairly easy to see when they are rising too quickly.

(Phil Smith is Editor, South Asia and the views expressed in this column are his own)