State of the Market|Reading the Psychology of the market

Yesterday, Nifty made a massive turnaround and in a single day climbed not only above 50 day moving average but also above 20 day moving average. It was a phenomenal move no matter which way you look at it. Now - the probability that Nifty might take out 5180 is very high.

Here’s one probable reason why market is behaving the way it is behaving: boat is not tilted too heavily on one side

A lot of the major market drops over the past two decades have their roots not in the underlying economy or corporate earnings trends, but rather in the complex mechanisms of the market itself

Here are following elements of market mechanism

1. How stock look on charts?
2. Over ownership/Under ownership [read overvalued/under valued]
3. Hedging Structure of the market [Put/Call Ratio]
4. Liquidity Scenario

All the above play a key role in which direction market will move.

How stock look on charts - Overstretched

Source: ChartAlert [www.chartalert.com]

Overstretched market is a technical term. One of the best measure of overstretched market: Divergence from the mean. The mean is considered to be 200 dma. As you can see in the chart above, Nifty has not even once pulled back to 200 dma post moving above it

That’s not all - Our market has moved too far from the mean and any time mean reversion may come into play. Mean reversion works as a realty check as market removes froth from the system and prepare it for the next move. It keeps the market healthy for the next move.

Remember, Trees don’t grow to skies and Stock prices don’t go to moon

But the question - Is there froth in the market? Remember, one of the reason why market has been so far from the mean: Breakaway Gap that got formed post election results. It worked more as an price adjustment event. Let us look at the second factor..

Over ownership /Under ownership

One of the reasons why our market despite looking stretched on charts is not tanking because it is not so overvalued. And remember overvalued means it should get ridiculously valued..not overvalued by small amount. On a 12 month forward basis, India is trading at 17 times. That’s not horribly expensive and with earnings upgrades probable…for some - our markets may be reasonable too. Remember - market gets overvalued because too many people want to own a stock disregarding fundamental value. The Performance anxiety becomes the decision criteria to own a stock and not the fundamentals. I do not think that’s the case right now.

Our markets are overstretched but not overvalued

Hedging Structure

Markets don’t tank when everyone is hedged. There has to be surprise element in the fall. Market will not fall when everyone has booked profits at 5100, sold call/bought put. There has to be element of disbelief in the trade.

Liquidity

The dollar rally scare is over and it seems to have no impact on liquidity. PLUS Domestic Liquidity has worked as an excellent hedge in any uncertain period and it has protected the market from downside.

Summary

If you look at all the elements - you cannot make a judgement that boat is too tilted on one side in favor of bulls.

Market will not fall just because it is overvalued or just because charts look stretched. Sometimes overvalued stocks keep rising because they are under owned; and performance anxiety drives up the prices. I guess market needs to build some froth/frenzy before it can revert back to the mean.

Also, sometimes we underestimate the power of the trend and how long it can last.

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Disclaimer - The state of the market notes is Deepak’s perspective on the market. The column is purely for educational purpose. Nothing contained herein is a solicitation to trade or a recommendation of a specific trade. By reading this publication you agree to make no trade relying in whole or in part on the comments of the writers

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