Warming Up

10 August 2020

Warming up! 

The heat is on, on the street
Inside your head, on every beat
And the beat's so loud, deep inside
The pressure's high, just to stay alive
'Cause the heat is on

To some people it feels more like overheated but I am saying Warming up. There is a reason. Sentiment on the street is nowhere near over heated. It is more like ‘’does not make sense’’ so ‘’must be bearish’’. The ‘’does not make sense’’ has its own list of reasons. They are wide ranging from the Pandemic and its second round effects to the general lack of activity as perceived by them in their personal business. Even then some sectors are booming and have taken advantage of the situation. The truth is people are saturated and waiting to get back to working harder. In the meantime it is true that many more have taken to the stock market like never before.

In this month’s report I will go over why I think that the bear market is over and where it is headed next. The first part repeats my conviction and reasons for it. The second is the outlook from here.

Let me waste a little time on history and why I changed my market stance. The economy was overheated and stretched during 2015-2018. While growth continued in some sectors the debt and NPA problems were resulting in falling credit growth and declining GDP growth rates. Worldwide too growth started to stall after 2017 and by the end of 2019 US was the only market holding its own on the back of FED liquidity. In that environment I was looking for a potential bear market that would take down the Nifty and stocks into a deflationary decline. I was open to Nifty levels anywhere between 6800-5100. This was me in 2017-2020. During that period many stocks and sectors rolled over one after the other. The Midcap Index fell 48%,

But it made sense to call that top as the Relative strength of the Midcap index to Nifty was at the top end of this range and later with a negative divergence with Nifty. Now we are at the bottom end of the channel on the ratio with a positive divergence to Nifty.

The Auto Index dropped 62%, and many individual stocks lost even 90% going deep discount to book value or dividend yields far above interest rates. In short the expected crash occurred in stocks but did not reflect itself completely in the Nifty. A bear market 2-4 years long has actually taken place in many parts of the market.

When the post Covid bear market started I did think that the final phase of this bear phase was starting and it was going to be the one in large caps for another 2 years down for Nifty. The first wave of the bear market would bottom at near 10500 then bounce then fall to 8500 then rally again and so on for the next 12-18 months. What I did not expect was a one way street to 7500. When we got there the decline was so fast at 100s of points a day I thought my 6100 level could come in days. I made a plan to buy nifty on every dip there onward. This was probably the first step to conviction that the bottom was in or near. The best way to be convinced is have a trade and if it rewards you then you are right. Now of course all I was looking for was wave B that often results in a 61.8% retracement. From 7511 that meant 10550.

Unfortunately I never got to average my way down. The market has only kept rising since then except for that one pullback in the first week of April. At that higher bottom I had to make up my mind on whether we are going back to 6100 or not. And even if we did it would be the last chance if at all. This was also where I already made the call that Pharma sector was bottomed out. Being a defensive sector maybe it bottomed early. Next sector charts of Auto and Metal indices were ending wave Z, so I started to ask the question, is the worst over?

The following Nifty chart later became a reason to be more convinced. The 2008 bear market took 4 quarters for the Nifty to fall to the 40 quarter average. In 2020 we got there in 1 quarter alone. On both occasions we did not close below it. So if markets hold above this the worst maybe over on quarterly charts. For more history I have used the chart of the Sensex below, the green line is the 40 quarter ema.

Next at 7500 sentiment was already as bad as has been seen at the end of any previous bear market based on any number of sentiment gauges from consumer sentiment surveys to the VIX near 90%

The above is a dated chart so here is the latest from the RBI report, the confidence continued to drop after March, so we do not have a rebound in sentiment as yet from consumers even though the expectations survey shows a divergence.

The last time the VIX was near triple digits the 2008 crisis was about to end.

The reason some of these measures like the survey and consumer spending etc. went off a cliff was not the Pandemic. It was because the economy was already in decline for one year ahead of the Pandemic. It took only the smallest hit for readings to get there. In fact sectors like Autos were in a bear market since 2018 so waves W-X-Y had already formed on that chart. Jan 2020, was an X wave and the March fall the final wave Z that ends a bear market. Same for Midcaps and metals indices among others.

All these technical and sentiment readings were staring me in the face and that meant I had to call a spade a spade. In Simple words

The Long and Short of it

1. The bear market is over at 7511 on Nifty and we are not going back there
2. The Reflation trade backed by a falling dollar in the US driving up commodities prices as explained in the May 2020 long short report was going to provide the liquidity fuel for the coming rally. It will drive a new bull market in commodities and stocks that benefit from rising prices of metals, precious metals and agro commodities.
3. This bear market did not end the economic winter because the debt is being bailed out again with more debt or direct debt purchases [monetary expansion]. This can result in inflation stagflation or hyperinflation, and we do not know which yet. This is a process so inflation will not show up for a year or two because of the recent slowdown. Central banks [at least in US as stated], will ignore the inflation metrics to some extent.
4. So the bear market in wave 4 is over
5. A new bubble bull market in wave 5 of larger degree backed by global liquidity from central governments and central banks, both, will develop. Ride it
6. The dollar bear market goes on to 2024 based on past estimate of cycles. So we have a 4 year time zone for the 5^th wave to complete.
7. The most beaten down stocks [not tarnished by the debt defaults etc.] will give the highest returns as they come back from undervaluation to normal value. If they manage to get growth back with a new story then even better. Find Value stocks and Midcaps that fit the bill.
8. Banks will underperform. Bank stocks lagged behind the US and European bull markets after the Great financial crisis. Now Indian banks will do the same as they bear the burden of past debts NPAs and the pandemic. Those losses will slow them down and they will need new rounds of funding that will expand their balance sheets. Look for pockets of second line financials with cleaner books. Newly listed banks and financials fit the bill. Under perform does not mean go down but rise less than main indices.
9. The new bull market will also get fuelled in India by savers moving out of FDs and other fixed return instruments that yield less and less in a search for yield. The retail investment bubble is just starting to build and the recent jump in participation reported by the media is on the start of something bigger and not the end of the trend or a trap of sorts. As long as interest rates are on a trajectory downward in India this trend will accelerate in the coming years.
10. Low interest rates and inflation will eventually justify the higher valuations in large caps. The real deep discount is in stocks that are not at those high PE levels and at discount to book. Large caps will eventually see revenue growth from the inflation that will get justified on Mcap to Sales ratios and similarly Profits will normalise. Problem is today no one has a timeline on this as the Pandemic is not past. For this reason the idea of normalisation is not being accepted. But this much should be clear that the worst is over and things can only improve. The problem of speed is being addressed by unprecedented liquidity

By the time the market figures out the impact of all of the above do not expect it to be at 10000 or 11000 in terms of the Nifty. Suddenly a much higher base will appear justified. Markets are not going to wait for you to be sure that all is well. Smart investors will always front run the market. After all Nifty is up from 7500 to 11200 as I write this piece, that is 49% up. You think this market is up 49% because of a “Weak retail hands buying and they are stupid” thesis. No. FIIs missed this bus as they are waiting for positive news, but note they did not sell the house and go away as far as India is concerned. They are sitting tight, buying very little at a time. Domestic MFs and PMSs got stuck in this crash and their conviction is shaken. That will change with the market itself. As the tide continues and their flows revive so will their confidence. So if these two were not the largest buyers who were? Smart Investors, call them Operators or large investors or HNIs, choose a name for them. While you may hope that MFs save the day or something like that it is an illogical thought. Reason? MFs/FIIs always depend on flows. They are always mostly fully invested with maybe 5% cash on the side if lucky. They are dependent on flows from retail investors to buy more. So by nature in a falling market they do not have the money to support it and sell to meet redemptions, and in a rising market they are flooded by rising fund flows and forced to deploy.

Contrary positions against a falling or rising market are always taken by the smart money represented in NSE data by “Client”, and this chart more than proves it. At every stock market top and bottom FIIs are maximum bullish or maximum bearish. Not the other way around. So at a top in the market who is maximum short? The “Client” category, which includes everyone that is non-institutional. Yes retail, but at large HNIs Large investors often called operators or just say smart money. This is important to understand conceptually.

The chart above shows two important tops in 2015 and 2016 prior to which The blue line at the top shows the highest long positions at that time, and the opposite shorts at the bottom in client data for index futures. Repeat similar situation before Demonitisation. The chart below shows what happened every time FIIs were more than 100,000 contracts short on Nifty. [yes my data is adjusted for previous changes in lot size so it may not match your data if now adjusted]. March 2020 was the only event where this extreme short position [the highest in the history of the data], was reached early in March much before the bottom. On other occasions the two were close to each other.

It is true not only in India but even the US. The CFTCs commitment of traders report publishes the F&O data for futures markets and whenever “Managed money” has maximum long positions in a commodity or stocks, the market tops out. The commercials are the smart money. Managed money refers to Hedge funds and traders Portfolio managers etc. That is not retail. Commercials are producers and other funds. The Fund industry therefore is the largest herd in the market as they depend on flows from retail which is sentiment driven. You have to look at the other side and take a contrary stance on the market.

But the market has many sentiment indicators and you can match which ones fit the bill at a point of time. This time the Nifty futures premium or discount was my guiding light. The persistent discount seen between May and June was off the charts. Even though June is your typical dividend season that drives down the index premium this time’s readings were lower than most previous years and so it should be noted. What I did then was avoid the raw number and run a 30 day average on it as seen on this chart. The reason is the lowest since 2008. In fact in July the reading was even lower than in March because of the persistence of the discount. So even though we saw the highest discount of the last few months in March the 30 day average is lower in July. What the chart below shows is the start of the process of mean reversion. The discount is turning toward zero and will slowly go toward a premium in my opinion. Some people want the market to top out on a zero discount, as they believe it reflects short covering is over. A discount in index futures is a function of both short selling and a lack of buying. It takes longs to get back to even. So the demand side has to come back. And the history of sentiment shows that the average will tend to 15-30 points before a top. So what’s the hurry? Bulls are just coming back, let them rage a bit.

I have set the stage, the worst is over and the sentiment is just starting to warm up to the idea that the market is bullish. So this is no time to wait for a crash or correction. The big change in my wave count is marking the 7511 low as wave 4 as seen on the Sensex chart at the beginning. So we are now in wave 5 up for Nifty. This should be a 5 wave rally on the way up. Start marking it so, and change your perspective is how I have handled it. We are then in wave 3 of the advance from the wave 2 bottom in May. How far will wave 3 go? It is an ongoing story of trying to count the third wave. My current outlook as seen on the chart below is for wave V of 3 to unfold which can go to 12,700 if it is equal to wave I of 3. This will put us at an all-time high and very close to the monthly Bollinger band of 12,920. Wave 3 and 1 will have achieved equality at 11,600, and therefore above that we should consider an extension in the 3^rd wave. If wave 3 is 161.8% of wave 1 then we end up just above 13,300. The current market outlook should therefore remain bullish till wave 3 is complete in all respects.

If all this is true imagine where wave 4 and wave 5 will eventually end. But here is an alternate scenario that I believe is less likely. It fits the fundamental narrative but might not be technically true. If there are future events that will slow down this market advance then it can cause volatility and sharp declines within a broader range before we breakout beyond 13,500. This could be in the form offer long term triangle formation inside wave 4. In other words while the low for wave 4 has been reached at 7511, wave 4 can also result in a triangle, which involves a contracting structure from that low to a higher high. A triangle marked is A-B-C-D-E involves higher highs in wave C and wave E. What we do not know is whether waves B and D will be downward slanting or upward slanting (as in the case of a running triangle). While 4^th wave triangles are a technical possibility, I am giving this less weightage because of the unprecedented economic stimulus being provided to financial markets.

A lot of people are interested in knowing what will happen to the bank nifty in the event of a new all time high in nifty itself. I believe that banks will go up with the rest of the market sentiment improves however they will lag behind in terms of performance as they have since March. The impact could be very similar to that seen on US banks after 2009. This chart shows the Dow Jones along with the Dow Jones bank index to highlight what I would expect to happen with bank nifty as well.

The real gains then will be made in Midcaps in specific sectors like metals, pharmaceuticals, autos, food and Agro or other individual stories where new value stocks turn into growth stocks. Valuations purely based on the nifty might end up appearing persistently high. Chart courtesy Vivek Patil. History can change ones perspective of things. I think you should prepare for a Sensex PE of 34 all over again, and we are at 26.41 only.

Other Sentiment indicators

The most important one this time is going to be the A/D ratio because the market rally has seen a lot of rotation during which individual stocks have actually seen a correction that is reflected in the declining breadth in between. After reaching an extreme the A/D ratio actually came down to the 1^st red line  on this chart. I see the ratio now recovering from it, and many market lows are made near the 1^st line itself especially when the trend continues to extend on the upside. The recent breadth therefore should continue to push stocks higher till the ratio goes back to near the highs of this range.

The India VIX is slowly coming down and I am trying to anticipate that it will make a higher base may be closer to 15 and then stay between 16 and 30, just like it did after 2004.

The open interest put call ratio in the short-term had a few negative divergences that caused near-term market corrections but nothing significant. It is currently neither overbought nor oversold and does not tell us much. The volume of puts to calls traded however is coming down slowly and has broken the rising trendline of this chart. The level is back to where it was at the Jan top, however we have seen much lower readings before and where we go will completely be a function of what type of market we are in. If this is an extended rally then anticipate that the volume PCR may go back to near 0.3 before we get a meaningful market top.

The difference between the open interest put call ratio and the volume put call ratio is important. The two tend to move in opposite directions. The open interest put call ratio tends to go up with price and similarly down with price action. The reason is option sellers sell more puts during a rising market as a sign of their confidence that the trend is likely to continue. This causes the open interest in put options to go up as prices go up pushing up the PCR. Similarly in a declining market option sellers sell more call options and the call open interest expands pushing down the PCR. This indicator serves well for short-term trading. The volume put call ratio however is more of a medium term indicator as it shows the sentiment towards trading in puts versus calls. It is surprising to note that a falling market attracts more volume in puts even though the open interest in call options goes up more. The reason has to do with traders that tend to close out their positions faster [buying and selling puts] than option sellers [selling calls] that hope to earn the entire premium up to expiration. Therefore the volume PCR moves more slowly and reflects the medium term sentiment of option sellers in the options market.

The participant wise open interest data from NSE for FIIs and clients is not showing any important trend worth talking about. For almost 2 months their positions have been near 0, plus or minus 10,000 contracts giving no clear indication of either direction.

The big picture charts and story

In the big picture the story starts with the dollar, in the dollar index started a bear market in 2017. After the double top in 2020 we are now in a 3^rd wave decline long term that can go on till 2024 based on a 7 year bear market, similar to that seen in previous dollar bear markets. On an immediate basis we are in late stages of wave 3 of this fall from the March top. Sooner or later there will be a bounce back in wave 4 that would last for a couple of weeks and retrace may be 38% of the 3^rd wave. Eventually we are headed lower in wave 5 of that structure to still lower lows. What we do not know in all this is whether the 5^th wave itself will further subdivide into 5 waves. After all this is going to be a long winding bear market with several rallies in between. Currency bear markets can often be one sided where bouncers are not significant and therefore calling for big retracements is not easy.

The most direct impact of this has of course been on precious metals. Gold was in a bull market since the 2015 low of $ 1050. We are now in wave 3 of that bull market, in fact we are in wave 3 of 3 that is in late stages. After a 4^th wave pullback wave 5 could eventually end up at $ 2500 if it is equal to 161.8% of wave 1. This 5 wave advance itself will only be wave 1 of a multi year bull market.

Silver has been left behind for a long time because of its industrial nature. This often leads to intermarket divergences between gold and silver at major turning points. This is exactly what happened at the 2020 bottom when silver fell below the 2015 low, even as gold held up at a much higher level. This signals that the worst is now officially over for both. The next major resistance for silver is at 36 [when gold was 1800]

This inter market divergence marks the end of the silver bear market and from now on both the precious metals should rise together and in fact silver should outperform gold, driving down the gold silver ratio from what was an all-time high in available data.

The 2^nd impact is expected is on other commodities. Oil is at the fag end of completing wave 1 of its rally and therefore short-term upside may be limited. We should remain on the lookout for a wave 2 pullback at some point of time before a larger 3^rd wave advance can upper. Wave 2 need not be deep it could simply be a consolidation but it will allow us to understand the downside risk and the size of wave 3 from there on.

Base metals took their time but are all now in an upward trend with many having broken out of their downward trend channels in the last one month. These trends are likely to be short-term. In the copper chart below anticipate this to be a 4^th wave triangle structure and the 5^th wave then could end up taking copper to an all-time high above $ 5. The real breakout of the triangle will be above 3.04

Agro commodities never lead from the front and therefore they will join the move to higher inflation with a lag. Its impact on inflation metrics will be more important in countries that still include food in their core inflation measures like India. Most Western counterparts will ignore it unless there is a public outcry. Within the space I have taken interest in sugar stocks because sugar prices rallied from a 20 year trendline recently right out of a wedge like pattern marking a possible long-term reversal. This is a monthly chart of sugar.

Coffee prices have had my attention for a long time but they have failed to breakout despite several attempts. The market already seems to have taken to coffee stocks like Tata coffee and Bombay Burma. Coffee prices do show an ending diagonal pattern that we need to see a clear breakout of to confirm that a major wave to higher prices started.

What is not clear is the possible size of this inflationary outcome. We are simply going to see some kind of mild stagflation or is the hyperinflationary scenario actually possible? In a globalised world the answer to this might be difficult. As long as trade barriers are still not back on the table the free movement of goods and services means that if she and producers of food or other products will eventually use the arbitrage to supply whatever is demanded in any part of the world. A currency crisis only occurs when it is allowed to happen. With the Fed providing swap lines to multiple countries it is unlikely to be a global event. Even then excessive liquidity does drive up prices of goods and services and some level of inflation in consumer prices will be felt.

The bull market in precious metals mining stocks will also continue as long as the gold bull market is on. The HUI gold bugs index has just started a 3rd wave rally breaking out of the trading range held between 2016-2020. This rally will continue to subdivide into 5 waves and is therefore far from complete. The gold bugs index should eventually end up at an all-time high above the 2011 top of 640.

The nifty metals index is a complex correction that also visually looks like a triangle, both triangles and complex correction tend to occur in fourth waves and we should anticipate that the 5^th wave in base metals especially copper is indicating something similar for metal stocks as well. The metals index should go past all the previous highs to an all-time high in wave 5 and we will know when wave 5 is complete, only after it subdivides into 5 waves itself on a monthly or quarterly degree.

What the falling dollar has done in the past is drive some of the liquidity into emerging markets as well. Commodity producers themselves tend to lead in that respect and have done so this time around as well. Thus the AUD has strengthened the most against the dollar and INR the least. That said dollar bear market should strengthen most currencies and therefore the bullish outlook on USDINR has to take a back seat till fresh evidence shows up.

With that in mind I looked at Fibonacci ratios last month and took on this alternate wave count that shows a 5 wave rise complete from 2008 to 2020. We may now see a pullback to the 4^th wave region within this chart near 60. But that will only happen over the four year time horizon. The move down should be slow and steady with each level being tested. The ending diagonals lower trendline at 72.70 may be the 1^st support and below that 68.27 seen a year back and will be the 1^st major swing low where a decline may halt. In the short-term however a break below 74 is needed to confirm my thesis that a trend reversal for USDINR has taken place. Till that point of time it is still possible to argue a bullish case for the currency pair in which case it would diverge from what the dollar itself is doing. I would not expect that but would like to see 74 break to end the debate.

Rising commodity prices and Agro commodity prices anyway point to some degree of inflation. The impact of this will eventually be to put some pressure on interest rates. However because of the lag effect from the economic slowdown this may not show up in the data very soon. We could be a year away from even a stagflation like effect. In that time period with world Interest rates at their lowest levels in years, India is now on a path of joining the low interest rate environment that the world has become used to in an attempt at stimulating their economies. The long term trajectory of bond yields is down now and may have several hundred basis points to go before we see a bottom in yields. We may have however come to the end of wave 1 of bear market in bond yields [or a bull market in bond prices] for GSECs. A small bounce back or a consolidation in bond yields would be a good thing. That would be wave 2 and be followed by wave 3 down to much lower levels.

The direct impact of falling interest rates has been the resurgence of India’s retail investor. Direct equity investing that had taken a backseat after 2010 with many shifting away from the futures market and going directly into mutual funds is now coming back with a force, going by the big jump in new depository accounts being opened. These are not necessarily all the old investors shifting asset class, but also a new class of investors and a young generation willing to get involved in the investment world. The significant decline in returns from fixed deposits can be cited as the 1^st signal of the shift of savings to equity markets. I believe, if the above trend proves true, that it will eventually lead to lower interest rates and not just in bank deposits but across the fixed return savings instruments spectrum. Watch future action of governments in bringing down PPF rates or even PF rates as a sign that something has changed. Bond funds and GSEcs will eventually become less and less attractive for their yields. In short the flow of equity and new investors to the stock market marks the start of completely new phase that is unlikely to end in a speed bump but result in fuelling a massive bull run for stocks. This trend does not Mark the end phase often associated with bubbles.

Where this trend can actually become a bubble would be if the expectations of future growth are not eventually met by economic activity 1 or 2 years down the line. It would also become a bubble if the lack of growth results in significantly higher inflation that has to be popped by raising interest rates. In an environment where the whole world is high on debt higher interest rates are the pin that will prick everyone’s bubble. As long as the inflation Genie is under wraps, and interest rates are on their way down we have a strong case for asset class reflation across the board.

In such an environment liquidity can overlook fundamentals and overwhelm the bearish expectations based on it. In 2017-18 people could not understand why I was bearish on the market, now after the crash everyone is in a hurry to call the next crash because they finally understand what the last one was all about. But the market is not backward –looking, and requires you to think ahead. Even after some of the most significant economic reforms announced in the month of May in lieu of an economic package, no one is thinking one year ahead.

The long-term chart above shows the eventual trajectory for a 5th wave after we get past 11,400. The rising channel from the wave 2 low to the wave 3 high goes all the way to over 18,000 on the nifty. That’s how far a stock market boom or call a double driven by global liquidity and a shift in savings and investment pattern can go. I believe that the state will also be faster than seen in the prior period of 2010 to 2019. The prior period marked one of the lowest volatility environments seen in the market based on the HV or historical volatility formula. The chart below shows the Green line of my index futures fund NAV that plateaued in the subsequent period because of this reason. At the start of 2019 I was anticipating HV to mean revert and go back above the horizontal line where it has been for the Indian market in the past. I think that is likely to be the case going forward.

In this chart of the NASDAQ index, I look at what the leading index in the world today showing. It has now broken out on the upside of the rising channel from the 2011 low. The reworked wave count marks the break of the lower end of the channel as a 4^th wave. When fourth waves break the lower end 5^th waves also break the upper end, which is what has followed. The volatility seen in the last 2 years then starts to look like what we saw between 1997 and 1998 [circled] during the Greenspan era. During that period he made an attempt to hike rates. The dollar jumped up causing the South East Asian crisis. Eventually the Fed backed off and the tech bubble continued into unchartered territory for the next 2 years. We are now entering another such phase on the NASDAQ where it is breaking out of the volatile range to new all time highs. On this chart if I consider wave 5 equal to wave 1 then we end up at 13,500 as the next logical number on the upside. It could be more or less and continues to remain senseless to most.

Overlooked by most I clearly noted in my daily publications that the US rally was becoming broad based. It has been recently joined by the Transports Utilities and Russell indices as expected. These indices were under performing for years v/s the S&P and therefore their return is important. A broad based advance makes for a healthy market environment.

CONCLUSIONS

A broad based bull market has started around the world with participation returning from beaten down stocks and sectors that survived the down turn, in a new hope that the revival package will work. The value buying today is forward looking beyond a year. The liquidity shift from low interest rates is driving new investment interest. These trends go on for years so this move is not over. While we will remain on the look out for near term risks of a larger degre corrections we cannot start out with that as the base case. In the immediate period a Nifty rally back to all time highs is not ruled out. Stay on course for a 2-4 year bull run backed by a falling dollar and rising prices as the primary driver. Watch how other factors unfold and grow around this thesis. Gold might still outperform equities in this environment. Mining and agro stocks should remain on top of my list along with pharma especially midcap pharma. Speed has returned to financial markets and Midcaps and Smallcaps are back.