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Thursday, December 9, 2010

Some questions and answers about the current state of the Sensex

Things have suddenly taken a turn for the worse. Instead of moving up to touch new highs, as all the experts were predicting, the Sensex has made an about turn and started falling like a stone. Small investors who joined the bull party a little late and were enjoying a merry upward ride, have been totally taken aback. Should they sell at a loss? Should they ‘average’ their cost as the Sensex falls by buying at lower levels? Should they wait?

Lots of questions and very few answers. The experts are talking about 5500 instead of 6500 on the Nifty. Some are saying this is a good opportunity to buy. Others are saying it is best to wait the correction out. Here is an effort to demystify the current state of the Sensex through a Q&A format.

Q1: Is the Sensex in a bull market or a bear market?

A1: As long as the Sensex remains above its rising 200 day EMA, it is technically in a bull market. Like now.

Q2: What if the Sensex falls below its 200 day EMA?

A2: If it falls below the 200 day EMA and quickly recovers – like it did in May ‘10 – it is considered a test of support from the long-term moving average. If it falls below and stays below for 10-15 days, then it could be a trend reversal from bull to bear market.

Q3: What exactly is a trend reversal?

A3: A trend is supposed to remain in force till it reverses. A bullish trend is distinguished by higher bottoms on the Sensex chart. A bearish trend is distinguished by lower tops.

Q4: Can there be a short-term bearish trend within a long-term bullish trend?

A4: Yes, and that is exactly what is happening now. The long-term trend is bullish because of the higher tops and higher bottoms pattern since Mar ‘09. However, after touching 21108 on Nov 5 ‘10 the Sensex dropped to a low of 18955 on Nov 26 ‘10. It bounced up to reach a lower top of 20218 on Dec 6 ‘10 and started to move down again – confirming a short-term down trend within a long-term up trend.

Q5: Can the short-term down trend turn into a long-term bear market?

A5: Sure it can. It did so in 2008, when the FIIs started to sell heavily.

Q6: Aren’t the FIIs selling heavily now?

A6: Yes, they are. But that has more to do with year-end profit booking considerations, because most FIIs follow the Jan-Dec calendar year as their accounting year. End of year profits will enable them to declare dividends on their funds and give fat bonus cheques to their fund managers.

Q7: What about all the scams and corruption stories hitting the markets at regular intervals? Won’t they dampen FII investing sentiments?

A7: May be for some new entrants. But existing FIIs know how this country works. They are investing here because they believe in the India growth story. And corruption is considered part and parcel of India’s growth. Indonesia is far more corrupt than India, but FII buying has led to the Jakarta Composite index performing much better than the Sensex.

Q8: Aren’t the FIIs selling because valuations in India are stretched compared to those in Europe and USA?

A8: That could very well be a part of the reason for their selling. They can deploy their money anywhere they want. Buying a Walmart at a P/E ratio of 14 makes a lot more sense than buying a Trent or a Pantaloon at a P/E ratio of 44.

Q9: When and where will this correction end?

A9: That is a tough question. The immediate downside target is the previous top of 18500. The 200 day EMA is quite close to that level. It is possible that the Sensex may bounce up from the twin support of the 18500 level and the 200 day EMA. Or, it may drop down a little lower to 18000.

Q10: Should small investors wait out the correction or start buying now?

A10: It is very difficult to time the market. Most investors buy individual stocks, and not the Sensex. The index provides a guideline. Some fundamentally good stocks have fallen a lot more, and valuations are becoming more attractive. Small investments can be made now. Other stocks – with questionable fundamentals and management - may fall a lot more and it may be better to wait or avoid them. If you are in doubt, stay out.

The most disastrous practice is to buy a fundamentally questionable stock, and then average down as the stock price plummets. That is a sure ticket to penury.

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