Defining Our Risk In Indian Stocks

During the summer we started to see cracks emerge as the small and mid-cap under-performance worsened and the smaller sectors of the market extended their losses. The large-cap leaders in Financials, IT, Fast Moving Consumer Goods, and Energy, which make up the majority of the market's weighting continued higher and masked the underlying weakness.

In early September we began to see cracks in the leadership of the Financial Services Sector, with HDFC Bank (25% of the index) starting to stall out as the index continued higher. We highlighted that a failed breakout in this sector would be trouble for the market given it accounts for nearly a third of the weighting in the Nifty 500.

Shortly after that we saw failed breakouts above the January highs confirm in the large-cap indexes that were holding up the market. With Financials weakening, selling began to spread into the other leading areas of the market like Fast Moving Consumer Goods, Energy, and then finally IT. This lack of leadership and weak breadth underneath the surface left the market no choice but to correct further.

Toward the end of the month we continued to watch the Nifty Financial Services Index and the Small-Cap/Large-Cap spread as the major indexes saw an expansion of new lows and stocks hitting oversold conditions.

By the first week of October many of our downside price targets had been hit so pressing shorts was not an ideal strategy, but we weren't seeing signs of a tradeable bottom just yet. Instead of forcing trades we kept our more neutral approach and took attractive opportunities like PTC India as the market provided them. Other than that, we waited patiently for an improvement in global market breadth and Indian stocks, and momentum divergences to help identify when to get back involved on the long side.

Two weeks ago we finally saw some readings in our breadth measures that have indicated selling climaxes in the past, but we still had mixed signals from the market overall. Many of the major indexes rallied and unsuccessfully retested broken support, so we laid out the potential for new lows ahead in price that we'd want to see accompanied by an improvement in breadth and momentum readings.

And that brings us to today.

Late last week we finally got new (or a retest of) lows across most of the major indexes as breadth and momentum diverged positively. On Monday we got upside reversals in price that finally confirmed these divergences, and more importantly, allowed us to define our risk on the long side.

Below is an example of what we're talking about. The Nifty 500 made new marginal lows and quickly reversed to confirm the bullish momentum divergence by trading above the former low and support at 8,490.

As long as prices are above that level, we cannot be short and need to be erring on the long side. Below that level all bets are off.

Click on chart to enlarge view.

Here is the breadth divergence we were watching and waiting for. Prices in the Nifty 500 were making new lows, however, the number of stocks hitting 52-week lows has declined from a peak near 20% to about 7.5% during the Nifty 500's new low last Friday.

We've also seen the number of stocks hitting oversold conditions decline from a peak near 55% to 18% as the Nifty 500 made new lows last Friday.

These are the types of conditions we've seen at other tradeable bottoms in history, so we're erring on the long side as long as the major indexes are above their early October lows. If they're not, then these momentum and breadth divergences are invalidated and it's back to the drawing board.

The last thing I want to say is that whipsaws are common near bottoms, so remember our thoughts on risk management and position sizing as we start to put capital to work in the market. If the market proves our thesis wrong, we’ll have to get out of the way and reevaluate. We’re not here to be right, we’re here to make money.

We've written a massive 80 chart post for Premium Members of Allstarcharts India outlining our thesis in full, as well as individual stock setups offering better reward/risk than the major indices. If that sounds interesting to you, access it by starting a 30-day risk-free trial or join our community by signing up for our "Free Chart of the Week".

Thanks for reading and let us know your thoughts!

Allstarcharts Team