Sunday, January 31, 2016

About pullbacks, corrections and bear markets

After touching lifetime highs in early Mar '15, both Sensex and Nifty entered down trends that are now completing 11 months. FIIs have been in selling mode, not because India's economy is in a down turn. Quite the contrary.

Slowdown in China, turmoil in Middle East, oversupplied oil market, a gradually rising interest rate regime in the USA have turned FIIs cautious and heading for safety. That means exiting Emerging Markets and returning to their home markets.

Many Middle East sovereign funds have started withdrawing from India as well, as low oil prices have begun to hurt and have depleted their investing surpluses.

Domestic investors have shown greater maturity by continuing their fund SIPs and buying the dips. Mutual funds have been buying equities, but haven't been able to prevent the downward slide in Sensex and Nifty.

Many small investors are in a quandary: Is this a bull market correction, or is it a bear market? Should we buy the dips or sell the rallies? The answers to those questions is another question: What difference does it make?

Unless you are investing in index futures or index ETFs, the state of the market should not be of much concern. For a long-term investor, your financial and asset allocation plans should guide your investment decisions.

However, for the curious, here are some thumb-rules.

A pullback is a short counter-trend move that falls about 5% from a recent top, or rises 5% from a recent bottom. Often, a pullback occurs to a previous breached support or breached resistance level. 

In a bull phase, a pullback provides a buying opportunity to those who missed buying when the previous resistance level was breached. In a bear phase, a pullback is a selling opportunity for those who could not or did not sell when the previous support level was breached.

A correction is a counter-trend move that falls 10% from a recent top, or rises 10% from a recent bottom. There is no way of knowing before hand if or when a pullback will turn into a correction.

A correction in a bull phase is quite common, and should be anticipated and used as an adding opportunity by long-term investors. Short-term traders make money by selling the rallies during a correction.

A bear market corrects 20% from a market top. Again, it is very difficult to know in advance if a correction in a bull market will turn into a bear market or not. Usually, some fundamental change in the economy or global concerns trigger a bear market.

When does a bear market end? It often takes 2 or 3 months for a reversal pattern to form on price charts. Ability to identify such pattern formation can help investors to take early long positions.

The 5%-10%-20% numbers are guidelines for those who can't or don't follow technical analysis. To really understand the underlying technical status of the market, one needs to learn about long-term EMAs, support-resistance levels and Fibonacci retracement levels.

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