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Where is the stock market heading? - Part-1 - The Dow Theory

What a rally it has been in all the equity markets across the globe, after the recent crash! NIFTY has recovered more than 50% from the lows of 7500 and is still pushing higher as it currently stands at 10085 (June 3rd 2020). So what's next, where are we headed?

Before we dig deeper, a word of caution. This is a perspective based on historical data and major market events that have occurred in the past 100 years. Kindly do not relate your investment plan to the article, the sole purpose of the article is to gain information,which you might find useful, whenever you need it. Knowledge is the main takeaway of the article.

This might prove useful for long term investors, but if you are a trader, it might not be applicable. There are 2 types of traders. First type, the positionally unbiased trader who is nimble enough to accept the trend of the market and change their views, learn and adapt. The other type who are positionally biased, who can't digest a contradicting data point. They are sometimes so emotionally hooked onto their positional trades that they are disdainful. If you belong to the second category, you can stop reading and continue with your positional bias.

Coming back to the topic, since NIFTY has rallied so much, do we conclude that the fall is over and should we begin the accumulating on the dip or is there still some downside left? We need to approach this question logically. Let's consider the circumstances under which the rally has taken place. Between March 2020 and June 2020 what had changed? Nothing much except that the lock-down had been largely relaxed. But the damage is already done. An entire quarter (Q1 FY 20-21) had minimal economic activity. Though the market has discounted this, did the market discount the already slowing economy prior to the virus? The answer would be no. As an index, the market had been rallying up until Feb 2020. So the existing slowdown was not factored in. The crash was a direct outcome of global supply-demand slump caused by COVID. Even with the lock-down being lifted, there is still a knock on effect on demand, as people's bullish-ness has taken a jolt. Both as an entrepreneur and an individual, capital expenditure will be minimal for the foreseeable future. Risk is not a casual word anymore in the market. Hence it is not clear, when the demand would improve. That said, the Q1 results would not be painting a good picture when the earning declaration season starts in July. In addition to that, the economic activity data like GDP, CPI, PMI etc are likely to see significant contraction when they are ultimately announced in the coming months. Globally, the demand has taken a hit and as the countries start to review their import policies and their dependency on developing countries, the demand is likely to contract further. That leads us to the question, has the market truly factored in all the future data points that are yet to come? Difficult to say, but, at the moment you would be safe to bet against a rosy picture in the coming quarters.

However, this is just my perspective and you could definitely take an opposing view to this article based on your own data points and reasons. None of us can predict the future accurately, but what we can do is to prepare for any eventualities so that we aren't taken off guard. This article tries to remain true to that aspect of being prepared for any outcome.

With the context set, the expectation is tilted towards more pain on the down side for the equity markets. So, if there is a down side, how long will the market underperform? How much the market can go down further?

Dow Theory can help us understand the question regarding how long and we will cover this in Part-1. Fibonacci Retracements can give us some clues on how much the market can go down, if at all and we will cover it in Part-2.

How long can the market go down?

Dow Theory explains the basis of equity markets, how and why stock prices move and explains about market cycles. It has stood the test time as it was originally developed in 1896 by Charles Dow and Edward Jones. It's been widely regarded as the principles of stock market behavior. It explains the psychology behind price and volume movements. For obvious reasons we cannot cover Dow Theory in entirety in this article, but we will see it in brief to understand how long the market down cycle could last.

According to Dow Theory, the market moves in cycles. Up cycles are called Bull Markets, Down cycles are called Bear Markets. Each cycle has 3 types of trends.

  1. Primary Trends - Market moves upwards for Bull Markets, Downwards for Bear Markets. This trend could last for 1 year or more.

  2. Secondary Trends - Retracement moves within the primary trend. This trend could last between 3 weeks to 3 months and the retracement can be 30-60% of the primary trend.

  3. Minor Trends - These are price fluctuations ranging between 1-2 weeks. Traders generally target these moves to take profits.

With that defined, we had the longest Bull Market in history which started from 2009 till early 2020. A primary trend is considered to be ended if the market reverses by 30% or more. With the march 2020 crash, the market has fallen 39% from all-time highs, marking the end of a decade-long bull market. This begins a Bear Market in theory and no bear market has ended in just 1-2 months, in all history. By definition, the primary trend lasts at least an year as per Dow Theory. Going by that, we are nowhere near another bull market.

The rally which we have seen till now, perfectly fits the criteria set for the Secondary Trend.

Is it a pullback? Yes.

Is it within a time-frame of 3 weeks to 3 months? Yes, it’s been 2 months.

Is the retracement within 30-60% of the fall? Yes, so far the NIFTY has recovered nearly 60% of the fall from 12400 to 7500.

So time wise, the market has run ahead of time in climbing 60% in 2 months.

Generally, this paves the way for retailers to get sucked in to the rally so late, after seeing a melt-up as swift as the melt-down from all time highs. The fear of missing out takes a toll on common investors, making them enter the market in a zone where the risk to reward ratio is poor. But, for the institutional investors, this is the perfect storm for distribution, to offload their stakes on the retailers. That is why they call them the “Smart Money”.

So, moving on, a Bear Market has 4 phases. A Bull Market ends with Euphoria, where all negative news is discarded and the market keeps rising. This has been happening since 2019, when Nifty rallied from 10000 to 12400 discounting all the disappointing news from the global economy, paving way for the bear phases.

  1. Distribution Phase - The Institutional Investors begin offloading their stocks gradually. We have seen this happening prior to the fall in March, where FII were consistent net sellers for some months.

  2. Panic Phase - This requires a trigger. It could be anything. During 2000, it was the Dot Com bubble, During 2008, it was the subprime crisis, this time it's COVID.

  3. Consolidation Phase - After the initial panic selling, the market takes a breather and starts to consolidate by triggering a secondary pullback move. This could be a technical pullback where people who had shorted the market started booking profits or people who were waiting for a good entry into the market which they could not do, during the earlier bull market. In either case, the institutional investors again have the opportunity to assess the situation and offload riskier businesses. As the secondary trend eventually fades out, the market continues its slow and gradual descent downwards. If the severity of the economic conditions are too high, the market breaks previous panic lows or if the severity is benign, it could rebound after testing the panic lows again.

  4. Bottom-Out - To confirm a bottom out that signals the end of a bear market, the market needs to make consecutive higher lows and higher highs while forming the secondary trends. Since secondary trends tend to take 3 weeks to 3 months, confirming a bottom could possibly take about 3-6 months.

This pattern has been seen in all major market events over the past century. To provide some examples, take a look at the Dow Jones Industrial Average chart during the Great Depression of 1929. Notice that the fall was nearly 80% from the high! To top it up, the recovery took 2 decades. I am not saying the current event might turn out like this, but this is what history looks like.

Let's take a more recent example of the Great Recession of 2008. Below is the chart of NIFTY. It has a similar pattern to the DJIA chart above, but with lesser severity. The recovery took about an year and then the global markets went on the longest bull market run in history!

Dow Theory of Great Recession on Nifty
Great Recession Nifty Dow Theory

With that explained, it should be fairly evident to figure out which phase of the bear market we are currently in. We are currently in the consolidation phase after the panic phase that occurred during March 2020. Hence there is a scope of retesting the previous lows of 7500 or even breaking it, if the economic conditions turn out to be sour. Take a look at the current chart of NIFTY. Lets see if you can identify a pattern that matches with the 1929 chart and the 2008 chart.

Dow Theory on Nifty during COVID
COVID Nifty Dow Theory

That concludes part 1. I initially thought of covering it in 1 single article, but it was getting too big. The reader would lose focus and patience on seeing such a big write-up, hence I had to split it into 2. :-)

In part 2, we will see how Fibonacci Retracement can help us to identify possible bear market zones. We will look at technical charts and the accuracy of these levels could be surprising. The current pullback could face resistance between 10150 - 10450 (based on Fibonacci). If this level could not be broken on the upside, NIFTY could resume the downtrend. And there was a reason why 7500 was the zone from which NIFTY rebounded (again based on Fibonacci). If it breaks, the next zone would be 6300, but let’s wait for part 2 to see more about it.

PS: This is not a recommendation to exit equity and mutual fund investments entirely. Investors need to take a call considering their risk profile and by evaluating if the current exposure and asset allocation is consistent with their financial health. Being partially invested can soothe our fear of missing out, but it might not be the time for going all out. Not Yet.

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