Higher probability of correction in major indices

The Sensex is currently at all-time highs. The Nifty is very close to breaking its all-time intraday highs in January 2018. However, most market watchers are anything but euphoric. This is because the latest uptrend has been extremely narrow in its scope and it has not been backed by breadth indicators.

A strong bull-market is backed by several robust breadth signals. Trading volumes will be high. The number of advancing stocks will comfortably outnumber the number of declining stocks. The number of stocks hitting annual (52-week) highs will be much larger than the number of stocks hitting lows. Broader indices will have gained as much, or more than the narrow Sensex or Nifty.

None of these background breadth indicators are giving good signals at this moment. Current trading volumes of about Rs 140 billion/day (moving average of last 10 days) are lower than the Rs 155-Rs 160 billion/day being registered in the January-February 2018 period when the Nifty was last at these levels. There are more stocks hitting annual lows than annual highs at this instant. For example, 17 stocks hit highs on Monday at the NSE, while 99 stocks hit lows.

Broader indices are well off their historic highs. The NSE 500 hit a high of 9,895 on January 24, 2018 and it is down 5 per cent from those levels. The Nifty Large Midcap 250 hit a high on January 23, and it's down 7 per cent from those levels. The Nifty Smallcaps 250 is down 24 per cent from its all-time high, which was hit on January 15, 2018.

The advance-declines ratio has been negative for five of the past six months, with a brief positive period in April. This is again a clear signal of a narrow bull market. It indicates that retail interest has tapered off, since smaller stocks are largely backed by retail. The deep correction in small caps also indicates a lack of retail buying. Indeed, the only major buyers at the moment are the domestic institutions. The foreign portfolio investors (FPIs) have sold equity, and they have sold rupee debt even more heavily as well.

There are two possibilities at this stage. One is that sentiment turns around, perhaps due to the uptrend in the big indices. In that case, breadth signals will start going positive again. The rally to higher levels will then be sustainable. A turnaround in sentiment by FPIs would be critical in this case.

President Donald Trump trying to browbeat the US Federal Reserve into maintaining an easy money stance could be a possible factor in changing FPI attitudes. If the Fed decides to delay its planned interest rate hikes and slows down its “Quantitative Tightening” schedule that could indeed, lead to FPIs renewing their commitment to emerging markets.  

The other possibility is that the major indices will collapse because there will be a stage when the domestic institutions stop buying. Right now, DII bullishness is being driven by mutual fund inflows. Those in turn, are driven by retail investors. There’s actually no contradiction between the paradox of retail selling of direct equity and strong mutual fund commitments by retail.  Most of the retail contribution to mutual funds comes through systematic investment plans (SIPs) and those are minimally committed for six months at a time. There's always a bulge in SIPs during April due to the new fiscal. If retail sentiment remains poor, there may be a dip in SIP commitments in October. That could be the signal for a big crash.

Historically, it is unusual for a narrow bull market to broaden again, without a deep correction in-between. That doesn’t mean it cannot happen. But the chance of a big correction in the major indices within the next two months seems much the higher probability scenario.  

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