Friday, February 9, 2018

Is the Sensex going through a Correction or a Trend Reversal?

That is a question asked most often by small investors whenever there is a correction after Sensex touches a new high (or low). Like, now. 

The short answer is: probably a correction. 

Why not a trend reversal? We need to look at a long-term Sensex chart to try and find an answer to the question.

The weekly Sensex bar chart has two bear phases (in 2015 and second half of 2016) and two bull phases (first half of 2016 and 2017).

The first (year-long) bear phase started after the formation of a 'diamond' reversal pattern during Q4 (Mar '15). The reversal pattern gave a trend-change signal from bullish to bearish.

The index dropped below its 200 week EMA into long-term bear territory, but formed a 'double bottom' reversal pattern during Q4 (Mar '16). Again, the reversal pattern gave a trend-change signal - from bearish to bullish.

The first (two quarters long) bull phase topped out without forming any reversal pattern in Q2 (Sep '16). That gave a hint that a correction (2nd bear phase) and not a trend reversal was to follow.

The index touched a higher bottom and formed a 'double bottom' reversal pattern in Q3 (Dec '16), indicating the start of the second bull phase.

What happened in Jan '18? Sensex topped out after a 13 months long bull phase without forming a reversal pattern, but did form a large weekly 'reversal' bar (higher high, lower close).

Is it necessary that a reversal pattern has to form to indicate a trend-change? Usually, yes. Can a large weekly 'reversal' bar trigger a trend reversal? Also, yes.

So, why am I voting for a correction, and not a trend reversal? Let's put it down to an educated guess.

A raging bull phase can be compared to a large ocean liner moving at a good speed in mid-sea. Changing direction can't happen suddenly. It takes a while for the strong hands to liquidate and weak hands to give up completely.

Can the correction turn into a trend reversal? Yes, if FIIs continue their selling. (Finance ministry officials are in denial by opining that the 10% LTCG will have very little effect on FII inflows because Indian economy is growing.)

When will the correction turn into a trend reversal? A 20% correction from the Jan '18 top (shaded) will be regarded as the start of a bear market. For Sensex, that level is around 29150.

The Sep '16 Sensex top (shaded) was 29077. So, the zone between 29100-29150 is likely to be defended strongly by bulls. Any breach of that support zone would mean all bullish bets should be off.

What should small investors do? Don't be in a hurry to buy. No use trying to catch a falling knife. Weekly technical indicators are showing downward momentum and hinting at more correction. Wait for signs of bottom formation.

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