Given many of the Equity indices in India are heavily concentrated, it can be difficult to identify what’s really happening in a specific sector or industry group just by looking at the Nifty sector/thematic indexes.
The best example of this is Nifty Energy, where Reliance makes up a massive 37% of the weighting.
One way our process has adapted to overcome this issue is by using custom Equally-Weighted Indexes to identify the real trends occurring in these areas of the market.
Today, we’re going to look at an Equally-Weighted Index to identify what’s happening in the Energy sector and how we’re taking advantage of it.
First, let’s start with an overlay chart of the traditional Nifty Energy Index and our custom Equally-Weighted Nifty Energy Index (which has the same components, but equally-weights them).
Starting in late 2015, these indexes moved in tandem to the upside as stocks as an asset class were in a bull market. But in January 2018, when the majority of stocks in the Nifty 500 peaked, we saw a divergence form between these two indexes. While the Nifty Energy Index continued to grind higher for the next two years, led by Reliance, the rest of the sector was in a downtrend along with the majority of the market.
Click on chart to enlarge view.
After both experienced sharp declines in January-March, they’ve now recovered, but to different extents. The traditional Nifty Energy Index is nearing new all-time highs, while the Equally-Weighted Index remains stuck below former support, showing a continued lack of breadth in the sector.
Now the question is, will this remain the case or can more stocks in the Energy sector begin to participate to the upside?
One positive is that the ratio of the Equally-Weighted vs Cap-Weighted Nifty Energy Index is showing a bullish momentum divergence as prices make new marginal lows. This suggests some near-term mean reversion could be ahead in the coming days and weeks as Reliance pauses and other Energy stocks begin to move higher. With that said, this would likely be a short-term development and not one to bet on aggressively given the long-term trend remains to the downside.
In order to feel more confident in the broadening out of participation in the Energy sector, we would need to see two things:
1) The Equally-Weighted Nifty Energy Index reclaim support near 7,200; and
2) The Equally-Weighted vs Cap-Weighted Nifty Energy Index ratio stabilize and get back above its 200-day moving average for several weeks, something it hasn’t been able to do since 2016.
Until those two things happen in tandem, we want to remain selective in the Energy sector and own the stocks that have tailwinds from multiple market themes.
Stocks like NLC India Ltd., which could benefit from this short-term reversion to the mean happening in Energy, but will also benefit from outperformance in the Mid and Small-Cap segment of the market. More importantly, the stock has extremely well-defined risk at current levels.
If prices break above 51.50 on a weekly closing basis, then this failed breakdown and bullish momentum divergence thesis is intact and we can be long with a target back up towards 115 over the long-term.
Well-defined risk, multiple themes providing a tailwind to the stock, and an asymmetrical reward/risk ratio…what more could we ask for in a stock?
To conclude, the Energy sector continues to suffer from weak upside participation over the intermediate/long-term. With that said, we’re seeing some early signs of rotation in the sector and want to take advantage of it through names like NLC India Ltd.
From a longer-term perspective, Reliance is still the clear leader in the space, but we want to keep an eye on this short-term development.
Remember, every long-term inflection point begins with slow and steady improvements…and this may be the start of that process for the Nifty Energy sector.
Thanks for reading and please let us know if you have any questions!