Bull Markets Don't End In A Day...But They Do Correct Regularly

JC Parets
September 1, 2020

Monday's downside action in India's stock market was a notable change from the slow grind higher we've experienced throughout August.

The news is this move was at least partially caused by some geopolitical risk and the SEBI margin requirement changes taking effect on September 1st.

Regardless of the reason for this selloff, we're going to take a look at prices and see how it's changed our short-term and long-term outlooks.

Before we get into yesterday's action, I want to address the title of this post. We are, in fact, in a Bull Market. One of the ways we measure that is by looking at the percentage of Nifty 500 stocks are above their 200-day moving average, which is around 70% after falling to nearly zero in March.

Click on chart to enlarge view. 

Additionally, the majority of Equity markets around the globe are still trending higher from an intermediate and long-term perspective, so while one day's action suggests being more cautious in the near-term, it does not by itself constitute a reason to question our longer-term bullish outlook.

Pullbacks are a feature of markets, not a bug. But that doesn't mean we want to endure every drawdown along the way.

Take the Nifty Mid-Cap 100 Index for example. Prices could correct all the way down to 14,000 and the long-term trend reversal we saw off the March low would still be intact. But do we really want to sit through a ~15% correction if that were to develop? Probably not.

With that in mind, let's move into some of the near-term action and how we're adjusting based on it.

Here's the Nifty 50, which is running into overhead supply near 11,750 as momentum diverges negatively.

Yesterday's selloff did two things. It confirmed the bearish momentum divergence that's been building for weeks and it confirmed that there is meaningful overhead supply at this level that we were watching as "potential" resistance.

Also, note the slope of the 200-day moving average, which is flat and signifying a lack of long-term trend. Given that context, it's unlikely that prices will break out on their first attempt and likely need to endure some backing and filling before their next attempt.

So at the major index level, we have areas of overhead supply with momentum divergences being confirmed. Now let's see what's happening at the sector level.

Here's a leading sector, Nifty Pharma, which is resolving its bullish flag pattern to the downside as opposed to in the direction of its underlying trend. This is an "oops" that signifies sellers have taken near-term control.

And here's a weak sector, Nifty Energy, with momentum diverging and failing at its former highs. The broadening of participation we were looking for is just not getting going just yet. Notice the flat 200-day moving average which is also signaling a lack of long-term trend.

The fact that many of the strongest AND weakest sectors are resolving to the downside, as opposed to the upside like we've been seeing for months, is information we want to be paying attention to.

And then we're seeing similar conditions at the individual stock level. Look at leaders like Reliance, which isn't breaking down yet, but hasn't been able to resolve its consolidation to the upside. The direction in which this ultimately moves will be a big tell, especially given Reliance's weighting in the overall index and position as a market leader.

And even the strongest stocks in the strongest sectors like Chemicals are putting in a potential failed breakouts. That's a change of character from the many successful breakouts we've seen in the last few months.

And here's an example of a weak stock. Instead of breaking out to new recovery highs, it's failing at resistance and rolling over again. Again, a subtle but important change of character in the market.

And then from an intermarket perspective, there are some headwinds for stocks like the breakdown in USD/INR. If we look at historical correlations, a stronger Rupee has been an issue for stocks and this major breakdown in USD/INR probably won't help in the near-term.

So, a number of "potential" caution signs that have been flashing are now being confirmed by price.

Given how close we are to are near-term price objectives, it makes sense to be reducing risk in our portfolios and waiting to see if prices stabilize or if there is meaningful downside follow-through.

So what does that look like in practice? There are a variety of ways to reduce the risk of your portfolio.

  1. Raising cash by selling stocks at/near price targets AND/OR stocks showing relative weakness (i.e. the weeds)
  2. Adding short exposure (via indexes or stocks showing relative weakness)
  3. Using puts or other derivatives to hedge your long exposure
  4. Adding uncorrelated trades like Gold/Silver or other Commodities to your portfolio

Given there's only been one day of weakness and we are still in the midst of a bull market, we do not want to be flipping the book and aggressively shorting stocks. Instead, this looks like a good opportunity to use methods #1 and #3 to protect the gains we've accrued over the last several months.

Let's review them.

First, we can raise cash by selling stocks that are at or near our price target.

Examples like Laurus Labs, which has been a huge winner for us but has quadrupled since March, met our upside target at 1,200 as momentum diverged, and is now consolidating.

Or Tata Consumer Products, which has had a huge run and is just about at our price objective near 572. It's not quite there, but momentum is diverging and we want to protect profits so that this doesn't turn into a round-trip if the market does deteriorate further.

And then stocks that have been showing relative weakness (also known as the "weeds") have no room in a portfolio if the market is going to correct either through time or price. If these stocks couldn't rally while the market has been climbing for months, it's unlikely they're going to get their act together today. It's more likely that they are leading to the downside.

Names like Indian Oil Corp., which are already in a weak sector and are showing weakness relative to that group should be avoided/sold.

And if you own longer-term positions that you don't want to (or can't) trade around, using puts or other derivatives to hedge in the near-term is worth considering as well (option #3).

Regarding tactic #4, we've already got plenty of exposure to uncorrelated assets like Gold/Silver and other Commodities. We'd expect those to continue to perform in the face of any coming stock market weakness.

So what can we continue to own or be adding to eventually on weakness?

Stocks with strong/improving relative strength, solid momentum, and great price structure like "big bases" that provide us an opportunity with clearly defined risk and a solid foundation.

If you're already in them and have profits, but want to continue holding them long-term, we'd suggest "feeding the ducks." This is a strategy that allows you to take your initial risk off the table, while still leaving your stop loss at your original level where the trade was put on. In other words, you reduce your position size so that you can keep your stop at a level that invalidates the trade thesis, as opposed to placing it where you entered the trade and leaving on the full position size.

Remember, stops should be based on where the original trade thesis is no longer, not at an arbitrary level.

Names with these characteristics include Multi-Commodity Exchange, which broke out of an 8-year base. If you missed the initial breakout above 1,400, a retest of that level would represent a buying opportunity given the long-term trend is clearly higher.

Or something like Strides Pharma, which recently broke out of a base and confirmed a bearish to bullish trend reversal. If prices are above 490, any weakness in this stock should be viewed as a longer-term opportunity.

Or Timken India Ltd., which just successfully broke out of a 2.5-year base. Any pullbacks towards its risk management level of 995 would be an opportunity to add exposure.

To conclude: We've harvested great profits from the market over the last few months as the bull market really got going and participation in this "market of stocks" continued to expand. Today we're seeing a lot of upside objectives hit, momentum divergences confirming, and failed breakouts among leading stocks and sectors.

As a result, we want to be reducing risk by pruning our portfolios of stocks that are at or near our price objectives, as well as the weakest names that have yet to participate.

We'll be monitoring this next week or two of price action to see if there's any meaningful downside follow-through or if prices stabilize through time and set up for their next leg higher.

At that point, we'll have more information about whether it's time to get aggressive again or if we've shifted back into an environment where being very selective and trading both sides of the tape makes sense.

Thanks for reading and please let us know if you have any questions.

Allstarcharts Team

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