Archive for January, 2008

Understanding Corrections

The picture on the left is a typical correction that has happened across assets, across time frames. But not many market participants can say what the price would do now, go up or down. Correction is an overused and misunderstood term. And few understand the many wealth creation nuances built into it.

A correction is a reality for stock market participants. It’s discussed, debated analysed and forgotten when the uptrend resumes. But the term ‘correction’ is highly misunderstood in the market. And it’s the technician who can define it correctly, and an Elliottician could do it better in terms of degree.

So before we talk about how to trade in corrections and where we are in Indian equity markets, let’s discuss a bit more about what we mean by a correction. First and foremost, corrections are not unidirectional ie they don’t just happen on the downside. There are upside corrections and downside corrections. So a correction purely defined is a correction of the trend. And a trend can be up and down. Masses generally have a propensity to direction; they consider upsides as certainty and downside as uncertainty. A trader or a technician on the other hand knows that there is always a bull run going in some asset class as there can never be a market without a bull run. Unfortunately, owing to their homework, threshold level and asset bias, investors look at an asset at a time, which generally is the asset already in a bull trend.

Hence corrections are downwards for an equity player, which is in a bull trend. While corrections will be upwards for someone trading cotton or sugar considering the secular trend of multi-years is down for many commodities. But the definition does not just end here. There is a degree connected to every correction. Charles Dow defined three degrees viz primary (more than nine months), intermediate (multi-months) and minor (less than three weeks). Elliott on the other hand extended the degrees taking it three levels higher and three levels lower viz cycle (few years), super cycle (decade), grand supercycle (many decades) on the higher side and minute (few weeks), minuette (few days) and subminuette (intra-day). Now this might look a bit complex but only a degree defines how low or high a correction can go. And every trend starting a one minute trend has three legs up, which are separated by two corrections or two legs down. And after the three trend legs get over, we have a correction larger than the previous two corrections after which markets move to a higher degree and the process starts again subdividing higher on both scale and time.

Markets can move in corrections for years while a small investor may never understand or notice it. For example many agro commodities like wheat, coffee, sugar and cocoa have come out of more than two decades of correction of more than cycle degree. This is one of the reasons we never felt the harshness of food and agro prices as they were in a correction and not in a trend.

So if you don’t understand the degree, you don’t even know if it’s a trend or a counter trend (correction). And you will have no comprehension of the fact that a countertrend is a part of a trend and a trend could be the part of a higher degree correction. It’s only when you understand the degree can you say how long the correction can last or how deep it will be. For a simple investor the Indian rupee must be in a strengthening trend, but for an Elliottician who studies degrees of multi-years and decades, the rupee is moving in a counter trend against the multi-year weakening against the dollar that pushed the currency from Rs 17 to the dollar in 1990 till Rs 48 in 2002.

Trends and countertrend work on all assets, and even on the Sensex. We may try to convince ourselves that the Sensex is in a unilateral move to 36,000 or 40,000, it will be wishful thinking, far away from reality. Before that happens, we will have corrections correcting the existing trend. So a seven year trend needs at least a nine-month trend down or sideways to correct. And if markets get into a corrective of over a year, all prayers will come to a naught as the trend will seize in its path and remain till the time it decays, corrects and wastes the time it has to rebuild or reconstruct. This is why we keep saying that markets have life; they also need energy and strength to move up. It’s not some rocket with unlimited fuel. The market is as human as all of us, just that it’s an extension of many humans, a complete society.

So corrections are an integral part of the trend and cannot be wished away. Though they bring in chaos, there is no order or trend without them. And hence, understanding a correction is as important as wealth creation. Investors who understand corrections and their extent are better prepared than ones who see every dip as a correction and every rise as perfect. If only it was that easy. Correctives not only come with degree but also have a form linked with them. A corrective could be sharp or sideways. It was between these two types that Elliott classified 13 forms. And even if you starts seeing them, which is easy, it is the believing part which is tough; believing that markets work on mass psychology patterns and fractals and not on economic valuations.

We are in an ongoing primary (more than nine months) five wave up (final leg of three legs up), which is a part of the Super Cycle degree of more than 30 years. The current move up should complete sometime this year for the Sensex. This means that every correction that happens should not last for more than multiple weeks after which the trend up should continue. Any dip that started from the recent top near 21,000 should not move below 19,000-18,000. After that the final leg up also called as the fifth wave of intermediate (multiple months) should begin taking markets to new highs. Whether this turns out right is of course connected with the skill and experience of watching and understanding corrections and labeling them degree by degree. It’s definitely more risky then calling every dip a correction. But then risk has a return side too. Let’s see how low this correction takes us.

For further inputs on what corrections mean for GLOBAL and INDIAN Indices for the week ahead download the fresh updates on WAVES.GLB.210108 and WAVES.IND.210108 from the site, or from Reuters knowledge platforms or write to us for a free trial.



Just like 2007, we will see the sectors shift in and out of relative strength. And as Sensex keeps growing, its sectoral representation will increase or decrease based on how well the sectors perform. New sector leaders will get in the Sensex and underperformers will get out. While a high and higher Sensex might seem good for the economy, it will never convey the real picture early enough to make the most of high performing sector growth or early warning systems to get out of stagnating sectors.

This is what we tried addressing last year when we said that Energy and Materials sector should lead the Sensex higher after the first quarter of 2007. On the Energy front we also mentioned that we do not see Oil falling substantially below $50 and after Oil hits base, the respective sectors should assume leadership. We also mentioned about Auto and IT underperformance, which happened. There was another aspect we got right, we anticipated a negative trend till March 07 and a positive year turn around after that. About the things we got wrong…we were off mark on the Banking sector, as we suggested pre budget Reductions. BSE BANK moved up 66% in 2007. The banking sector indeed pushed us off our Sensex targets, which we did not foresee above 18000.

So as you see, the answer to Indian stock market outlook is trickier than the famously quoted “Sensex 40,000” in five years. We are not saying that it does not challenge us to get the target on Sensex right by two decimals (Elliotticians have done it prior), but market forecasting is extremely dynamic and to stick out for a potential turn level in 12 months is not an easy accuracy to deliver. However, Sensex targets can be built around sectoral and intermarket dynamics. The late economic cycle stage, which we discussed last time, is followed by topping and slowdown. After Sensex 20,000 market expectations are for 30,000, but we don’t see Sensex extending beyond 24,000 this year with the benchmark making a decade high this year.

Like we saw Auto, Pharma, FMCG and IT stagnating more than 15 months on average, while Sensex soared, it’s wishful thinking that Capital Goods and Banking will continue to outperform and will not pause if not exhaust. Sensex underperformed the Capital Goods, Banking and Energy sector in 2007. And these are the sectors which will finally validate our case. Credit cycles are behind the economic boom and even if India is sitting on a huge industrial and construction boom linked with the capital goods sector, credit and real estate are interwoven in the sector. Prices can’t rush ahead of itself and a rise of energy and material prices will only make it tougher for the capital goods sector to keep delivering, as costs go up. This year BSE Capital Goods sector should move its last leg up to complete the cycle trend the sector started in 2002. The index should complete the last leg up from current 20,000 levels to 25,000. This should be the first leading indicator after which identifying a Primary (multi year) top for Sensex should be easy.

And a move on Oil above $ 100 to potential $ 125 might look interesting to the energy speculators. But it will subdue the enterprising efforts some of India’s underperforming Auto sector majors are making to bring in luxury cars pitching to buy them from the other struggling global auto majors. Not to forget to mention the other ill effects of rising energy prices. So after the damage will be done by high energy prices in 2008, BSE Oil Index will also head into major resistances accompanied by primary (multi year) top on Oil prices.

Banking sector is also an early starter in an economic cycle. Sensex started moving up in 2001 four years after the uptrend in banking majors. So if Sensex has to form a primary top this year, Banking should lead. We are not looking above 15,000 on BSE BANK Index (up 25% from current levels). Bad timing as you may call it with Capital goods and Banking under pressure, Energy topping late 2008 or early 2009, we will be ready for the proverbial bust heading into 2010 and 2011 Benner cycle lows.

Selling in strength isn’t easy. We advise to reduce capital goods sector allocations and looking into Pharma and FMCG majors, which we consider defensive plays and emerging outperformers. About IT, we don’t see a reprieve yet, the negative surprises might keep coming. Utilities and integrated Metals and Materials Company should continue to fair well. From an Elliott count perspective, the 3 primary of the Impulse from 2001 has witnessed a double extension. And the best case scenario expects atleast a 3 Primary (multi year) top this year, as the sectors witness the relative shift once again.