Where do you think the market will be at the end of this year? Irrespective of whether the market goes up or down, if you knew the answer to this question, then you will be able to make a lot of money. We know that it is not easy to make a lot of money very easily. When it comes to predicting Indian market indices like the Sensex or Nifty, most market analysts have a dismal track record. At the beginning of 2015, majority of analysts, including those from the global broking houses, like Goldman Sachs, Morgan Stanley, Citigroup, Merrill Lynch, HSBC etc were predicting Sensex to be between 32,000 to 35,000 and Nifty between 9,500 and 10,000 by the end of 2015. We now know that they were more than 20% off their target. In the defence of these analysts, it must be said that, the market is very complex and determined by a large number of variables, both local and global, which makes the job of predicting the markets almost impossible. In our opinion, instead of trying to get a fix on where Sensex or Nifty will be in the next 6 to 12 months, investors should try to develop a framework which will enable to build rational expectations and form strategies that will help them meet their short term or long term investment objectives. In this article, we will discuss some elements of a framework for understanding market dynamics in 2016.
Although most analysts got their 2015 Sensex and Nifty forecasts horribly wrong, some of them have stuck their necks out and called the market to end 15 to 20% higher in 2016. As per a Wall Street Journal report, Morgan Stanley, Merrill Lynch and Deutsche Bank have a year-end target of around 30,000 for the Sensex. Goldman Sachs has a year-end target of around 9,000 for the Nifty. While we discussed earlier that the year-end index targets are not very useful for investors, the analyst outlook is indicative of their bullishness about equity market in India. Their positive outlook is based on their belief that valuations of many companies are attractive and that some of them are seeing green shoots of economic recovery in India. Also, the weak global sentiments which caused the market to relentlessly fall in the last few months notwithstanding, many analysts feel that the global risk aversion has been overdone and that they expect to see a recovery in major global markets at some point of time this year. However, I have not seen too many analysts prepared to call a market bottom. This implies that the market may fall further before recovering as per the analysts. Investors should therefore brace themselves for further volatility this year.
Volatility is stressful for investors, especially for those, who actively track their investment performance. However, for informed investors implied volatility is also a useful indicator of expected stock market performance. We should understand the difference between historical volatility and implied volatility. Historical volatility is the actual volatility of index or stock prices over a certain period of time, while implied volatility is the expected volatility in index or stock prices. An implied volatility of 20 means that the index is expected move up 20% or move down 20% on an annualized basis. Higher implied volatility usually signifies investor fear and lower volatility signifies investor complacency. When there is fear in the market, investors sell their positions and the market corrects. A study of relationship between implied volatility and market movement provides useful insights to the investor. How is implied volatility measured? Implied volatility is built into the premium of call and put options of the assets. The implied volatility index of the Nifty is India VIX. Usually a negative correlation has been observed between Nifty movement and India VIX. The chart below shows the daily India VIX index over the last three years.
Source: National Stock Exchange
While the VIX level is in itself an indicator of investor fear, the change in VIX is more useful indicator. When we study VIX chart, it should be remembered that the normal volatility levels in India are usually very high and major event can cause an extreme fluctuation in volatility. Therefore, as investors, we should ignore one off extreme fluctuations and focus on the trend of VIX. When the VIX level rises over a period of few weeks and months, it is an early indicator of a sharp correction. On the other hand, declining VIX trend is an indicator of market strength. For example the VIX was on an increasing trend from January to June 2013, after we saw a fairly sharp correction in the Nifty. The VIX was on a declining trend from September 2013 onwards, signalling a bullish sentiment in the market. The market rallied from September 2013 to early 2015. If we look at the chart above, we can see that VIX was on an increasing trend from December 2014 itself and maintained the trend into February of 2015. From March 2015 onwards the market started correcting. Therefore, if you study the VIX data over a period of time, you can get a sense of what to expect in terms of market movement in the coming weeks and months. You should not worry about how to calculate the implied volatility of Nifty. It is published by NSE on its website and is available on other finance portals as well. You should remember that VIX is a short term indicator and is one among several other indicators that will give you a sense of market direction.
Global factors will continue to define the narrative in the Indian equity market. I have seen that Indian investors delude themselves, influenced no doubt by the media and broking houses, into believing that, somehow we will be immune to global factors. In 2008, I remember, people on television channels were talking about India de-coupling from global market factors. The Sensex fell by 60% in that year, triggered by large measure by the Lehman Brothers collapse in the US and also global factors. Thankfully these days, people do not continue to talk so much about de-coupling as they did back then. We are living in days of increasingly globally inter-connected markets and Foreign Institutional Investors (FIIs) are still the biggest investors in our market. The fall in the Sensex and Nifty over the last one year has been triggered almost entirely by FII outflows because the domestic investors have been net buyers in the market. Two factors that are dominating the narrative in global equity markets are the Chinese economy and crude oil prices. They will continue to be important. But in my opinion, another factor, to which many people in India are not paying attention to, and which will become increasingly important, is the US economic recovery. China is a very large economy, but we should remember that the US is the largest economy in this world. Right now, the Fed rate hike notwithstanding, there are still question marks with regards to the economic recovery in the USA. While unemployment in the US has shown definite signs of improvement, there is no definitive evidence of pick-up in consumer demand. It is too early to definitively conclude whether the US is a growth mode. The commentary of Fed throughout this year will be an important indicator for investors globally. Like it or not, if the US goes into a recession, then we will be staring at a very serious problem. On the other hand, if the US economy is firmly on a growth path, the Chinese problem while cannot be ignored, will actually be of lesser consequence as far the global equity markets are concerned. The crude oil markets, of course, will continue to have a direct impact on equity markets. You may be wondering, is not falling oil prices good? Yes it is definitely good for consumers. In fact, since as a nation, India is an importer of crude oil, it is good for India too. Declining crude prices have helped keeping inflation in check. However, from an equity market perspective, lower crude prices are seen as indicators of weak global demand and economic slowdown. According to Goldman Sachs, however, the crude bear market is a consequence of supply demand mismatch. Normally, when there is a demand supply mismatch, prices correct and a new equilibrium is achieved in the market. The demand has not fallen as much as one would expect based crude price correction. However, we are in this situation, where the oil companies are not reducing their supply despite lower demand and hence prices are falling. Goldman Sachs believes that crude prices will bottom out when the oil producers simply run out land based storage for crude oversupply and have to look for more expensive floating storage. As per Goldman Sachs, crude is expected to bottom out by the middle of 2016 and then rise to $40 a barrel, this year itself. Finally, China is going through a transition from an export oriented economy to domestic consumption based economy. Such an adjustment is difficult and will take place over several years. One cannot expect positive data out of China anytime soon. The one thing markets will look at, at as far as China is concerned, are the actions by the Chinese Government with respect to the economy and the currency. The Chinese currency will be a major concern this year, since further devaluation of the Chinese currency will have adverse ramifications for not only countries in the region but for the global economy. Investors should keep an eye on the US Federal Reserve monetary policy, trend of crude prices and Chinese currency, to get a sense of market direction in 2016.
The important events that investors should keep an eye on this year will be the Budget, RBI monetary policy announcements and the expected Cabinet reshuffle. The other important information that will drive the market is the meteorological forecast for monsoon. After few consecutive years of deficit rainfall, early forecasts point to bountiful rains this year. Monsoon will be important, not only from the perspective of Consumer Price Inflation and interest rate actions thereof, but also rural consumption demand and its impact on revival of economic growth. Investors should also keep an eye on the NPA situation of the banks, when they declare quarterly results. The third quarter results of the banks did not show improvements in the NPA, and therefore weakness in Bank Nifty is expected to continue. More Government action is needed to alleviate the stressed assets of Public Sector Banks. Look out for any announcements from the Finance Ministry in this regard. Banks have the biggest weight in the Nifty and as long as the banking sector continues to be weak, we cannot conclude with any conviction that a market bottom has been found. On the political front, though a number of state elections are scheduled this year, it is not expected to have any significant impact on the equity market, because the NDA is not expected to do well in the upcoming state elections anyway except Assam.
While the Nifty fell by 20% in the last one year, stocks like Rajesh Exports, Chennai Petroleum, Dishman Pharma, Welspun India and Tata Elxsi grew by 130% to 300%. While these companies were among the exceptional performers in the market, there were many companies which gave well over 20% returns. On the other hand, some PSU Banks fell over 50% in the last one year. Nifty heavy weights like State Bank of India, ICICI Bank, Larsen and Toubro and Tata Motors fell by 35 to 45%. 2015 was clearly a bottoms-up stock picking market. Since the major factors underlying the 2015 market dynamics has not changed in 2016, there is no reason to believe that the investment approach which worked in 2015 will not work in 2016. Most capital market experts think that this is still a bottom up stock picking market. In addition to bottoms up stock picking, pay attention to important themes if you are a slightly longer term investor. The table below shows the performance of different industry sectors over the last 1 month, 3 months, 6 months and a year.
You can see that some sectors significantly outperforming others in the table. While we are by no means suggesting that themes will play out in 2016 in exactly the same manner as 2015, investors should pay attention to how each sector is performing. This can help you in identifying stocks within particular sectors, which can outperform the market. The themes that would interest would be cyclical revival theme spanning multiple sectors, the interest rate trajectory, consumer demand etc. If weakness in the economy and particularly the Indian Rupee continues, then the export related themes will be of interest.
I had discussed in my blog post, No end to volatility in sight: What should we do: Part 1, that technical levels are not at all useful for the investor in a bearish market. If you want to time the market, which is always a very difficult thing to do, it is advised that you tactically add equity to your asset allocation, at every major dip. While technical levels are of little significance in these conditions, technical analysis has some interesting tools, like moving averages, relative strength index (RSI) and MACD, which can give you a sense of intermediate term market direction. For beginners in technical analysis, daily moving average (DMA) is an easy to understand concept. DMA, as the name suggests, is the daily moving average of the asset prices over a certain rolling period. For example, the 30 DMA of Nifty is the daily moving average of Nifty over the last 30 days. The DMA itself is not as important as its trend is. The trend of 30 DMA will give you the short term direction of the market. The 100 DMA and 200 DMA will give you the long term direction. The chart below shows the daily Nifty price chart and the important DMA trends over the last one year.
The market is bullish if the 30 DMA is above the 100 DMA, which is turn is above the 200 DMA. In the chart above, we can see that the 30 DMA showed a reversal in trend in last year March itself, which should have been an early indicator for investors. The 30 DMA crossed below the 100 DMA in April and 200 DMA in May. This should have reinforced the earlier bearish signal. From August 2015 onwards, 200 DMA is above the 100 DMA, which in turn is above the 50 DMA. This is clearly bearish. Further, all the three DMAs are trending downwards, as of even today (January 27, 2016). Therefore, you should be extremely cautious while investing, unless you are long term investor. I have heard many investment experts saying on television that the market bottomed out a few days back at around 7300 or thereabouts on the Nifty. If you are an analytical investor, you should not be convinced about the market bottom, unless you see a reversal in the trend, starting with the 30 DMA and later the other DMAs. You need to buy a technical analysis software package to know the DMA trend; you can find the DMA charts in many market and investment portals, e.g. moneycontrol.com, economictimes.indiatimes.com etc.
If you were looking for a year end Sensex target or even the bottom level of Sensex, you would be disappointed because we have not ventured any guess with regards to target or bottom. However, we have endeavoured in this post to provide you a framework so that you can understand the market dynamics at play this year and form your investment strategy intelligently. If you are long term investor, a bear market is always a great time to invest systematically and you will reap rich rewards in the long run, (please see our blog, Making sense of volatility in the equity market: A Historical perspective).
An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13 years of management experience, mostly in MNCs like American Express and Ameriprise Financial, both in India and the US. In his last role, he was the Chief Financial Officer of American Express Global Business Services in India. His key interests are building best in class organizations, corporate governance and talent development
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