BSE Sensex Index Chart Pattern - Jul 10, '09

The following observations were made during last week's discussion about the BSE Sensex index chart pattern:-

'If the Dow continues to fall, the FIIs may decide to pull out in a hurry. The sparks of the fledgling bull market in India may get extinguished. If such a flight of capital happens - and I'm not saying that it will - the budget on Monday, July 6 '09 could provide just the trigger for it.'

Sure enough, the high fiscal deficit, left uncovered in the budget, provided the trigger for the flight of FII capital. The 2 years weekly bar chart pattern (on top) and the 1 year daily bar chart pattern of the BSE Sensex index shows that the stage is set for a possible chart pattern formation that I had noticed a few weeks back - an 'island reversal'.

Island reversals occur only once in a long while, but if they do, they are very good indicators of termination of intermediate moves. They often form part of an overall chart pattern, such as a head-and-shoulders.

So far, we have seen a deep bear market correction from the top made in Jan '08, followed by an intermediate up move. On both the 1 year daily chart and 2 years weekly chart, the 'gap' made on Monday, May 18, '09 is clearly visible. The head-and-shoulders pattern at the top of the intermediate up move is also apparent in the 1 year chart.

Observant readers will note that a similar head-and-shoulders pattern had formed on the daily chart during Aug '08 and Sep '08, prior to the huge fall in Oct '08. Does that mean the pattern will repeat? It might - but then again - it might not. Technical analysis is not a science, so trying to predict on the basis of past patterns may be foolhardy.

So let's talk about the possibilities. There are three likely outcomes:-

1. Monday, July 13, '09 could prove an unlucky day for the bulls if the BSE Sensex index opens with a downward gap, which does not get filled for some time. That would create the 'island reversal' we have been discussing. Why? Because all the trading from May 18, '09 onwards happened above the gap, forming an 'island' of trading, isolated from the main chart pattern.

That would open downward targets of 12500 and 11500. Those two levels correspond approximately to the 38.2% and 50% Fibonacci retracements of the intermediate up move from 7700 to 15600. 12500 also happens to be in the middle of the gap area and near the downward target of 12800 for the head-and-shoulder formation.

2. The Sensex closed last week at 13500, near the top of the gap. There is a possibility that the gap provides support and the Sensex continues in its intermediate up move for a while longer, targeting the 16000 level. This option should have the lowest probability.

3. The index can go down to meet its head-and-shoulders target, which will partially fill the gap, or go down to 11500 to completely fill the gap before starting its next up move. Because of the infrequent occurence of island reversal, this option is the most likely of the three.

On the longer term chart, both the RSI and slow stochastic are exiting overbought zones, indicating bearishness. The ROC is mildly bearish - still above the '0' line but dropping rapidly. The MACD is positive, but trying to go below its signal line.

Bottomline? Next week's trading will provide pointers to the future direction of the BSE Sensex index chart pattern. The weekend can be used for researching and shortlisting fundamentally sound stocks for one's 'buy list'.