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Saturday, October 2, 2010

BSE Sensex Index Chart Pattern – Oct 01, '10

Two weeks back, I had calculated a minimum upward target of 20600 for the BSE Sensex index, based on the upward break out from the year-long trading channel. The width of about 2100 points of the trading channel added to the break out point of 18500 set the target. Last Friday’s intra-day high was 20475 – just 125 points short of the target.

The question on every investor’s mind must be: What next? I can only quote Yogi Berra, the former New York Yankee’s coach, who said: It is very difficult to make predictions – particularly if it is about the future! Indeed it is. Specially difficult is predictions about the shorter-term future. If any one can truthfully answer the question, he can get seriously rich.

What about the longer-term future? That may be a little less difficult. So, let us have a look at a really longer-term BSE Sensex closing chart pattern covering the previous bear-bull-bear cycle:

SENSEX_Oct0110_LT

There is a reason why the 200 day EMA is considered the trend indicator in chart patterns – and it is apparent from the chart above. When the 200 day EMA is rising, and an index (or stock) is above it (whether the index or stock is rising or falling) – it is a bull market.

If the 200 day EMA is falling, and an index or stock is below it (whether the index or stock is rising or falling) – it is a bear market. It can’t get any simpler than this.

Note the sharp bull market corrections in 2004 and 2006. On both occasions, the index dropped below the 200 day EMA, but not far enough, or for long enough, to reverse the direction of the long-term moving average. During smaller corrections in 2005 and 2007, the index got good support from the 200 day EMA, and proceeded on its upward journey.

All those corrections were opportunities to add. Should you add more as the index (or stock) rises, or less? Logically, you add less as the index (or stock) goes higher.

Also, note the first bear market pullback in 2008, which took the index above the falling 200 day EMA, but not enough to cause a change of trend. The pullbacks in a bear market are opportunities to reduce. Again, logically, you sell less as the index (or stock) falls lower.

How do you know when to start selling? In a bull market, you make money by buying – not by selling. However, after sharp rises, you may need to do partial profit booking to get your asset allocation equation back on track. Which, of course, means that you must actually have an asset allocation plan! Thereafter, just maintain trailing stop-losses and keep riding the bull.

A few readers asked me if this is a good time to sell their entire portfolio and move to cash. It really depends on an individual’s risk tolerance and patience. But experience also helps to identify trend reversal points. Are we near one now? The technical indicators don’t suggest that. Could we have a correction soon? That is always a possibility.

Have a look at the RSI in 2007. As the Sensex moved up, so did the RSI. But see what happened in Jan ‘08 when the Sensex touched its all-time high? The RSI made a lower top. The MACD did likewise. These negative divergences gave warnings about a possible change of trend.

Compare 2007 with 2010. The RSI has made a higher top, so has the MACD. Both seem to be in sync with the Sensex. A correction down to the 200 day EMA can happen anytime – but that will be well within the ‘normal’ 15-20% correction range, and provide a good opportunity to add.

What about turning points in bear markets? Again, the RSI and MACD provide clues. The Sensex closing low in Mar ‘09 was a little lower than that in Oct ‘08. But the RSI and MACD made higher bottoms. The positive divergences signalled a possible trend change.

Many seasoned and well-known investors look down upon technical analysis. They are partly correct in doing so – because technical analysis is more art than science. But ask yourself this question: did anything change fundamentally between Oct ‘07 and Jan ‘08 to cause the huge fall? Or, did anything improve fundamentally between Oct ‘08 and Mar ‘09 to star the sharp rally?

I haven’t come across any fundamental analysis that can signal market turning points. Only technical analysis can provide some clues. But remember that technical analysis is prone to errors – mostly of interpretation.

Bottomline? The BSE Sensex index chart pattern is poised to make a new all-time high. Caution should be the watchword near market tops. But one shouldn’t feel scared or sell in a panic. If you are staying up nights thinking about the massacre of 2008, do take some profits home. But don’t sell off everything. Keep tight trailing stop-losses, and stay invested.

PS: Cup-and-handle bullish continuation patterns are supposed to work on shorter term charts. But the chart pattern of the Sensex during 2008-09 looks too much like a cup-and-handle pattern to be ignored. A rise to 24000-25000 in the not-too-distant future may be a distinct possibility.

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