Leading indicators for a market breakout

Economic fundamentals indicate that we are probably near bottom of cycle, however leading indictors of recovery are still not in sight.

Typically market itself are the best indicators of recovery and tend to breakout from their bottoms many months before a economic recovery can finally be confirmed.

However there do seem to be a few macro variables which tend to act as a leading indicator for a market breakout itself.

The analysis is based on how the recovery and market breakout progressed during the 2008 crisis, and on otherwise well known relationships between some of these variables.

The primary indicators are

Quarterly profit growth

An improvement in YOY percentage of net profit would point to an impending breakout in a few months. And the first time that quarterly profits show a positive growth (even if sales growth is negative) after a period of de-growth, the breakout would have just happened or about to happen.

Monthly WPI Inflation

WPI inflation less than 5% would point to an impending breakout within a month or two.

Given that the Sept11 quarter net profit profit showed a decline of around 23% YOY and Nov WPI Inflation is at 9.1%, we seem to more than a few months away from a decisive breakout.

Secondary Indicators

There are a few other indicators which can probably be used as more of confirmatory indicators rather than primary indicator due to reasons of volatility/ data reliability /variable being a decision of a person (e.g rate hike)

These are :-

- YOY percentage change in IIP to show improvement (even if means a lower negative number). Breakout likely to happen almost immediately .

- Commodity price indexes would make new lows and start to rise just prior to breakout

- US Govt 10 year yields would form a bottom a start to rise. The rise in the 10 year yields would precede the breakout in S&P 500 in US. And I am assuming that we need to see some kind of breakout in S&P 500 for the breakout in domestic equities to sustain

- Advance tax estimates of top 100 companies likely to show an uptick a month or two before breakout

- FII monthly outflows to slow down compared to immediately preceding six months. This one is very volatile and FIIs have not been been as bearish as in 2008 period, so I would use this with a pinch of salt.

- Gold likely to correct 15-20% from its 52 week highs a few months before breakout

- RBI would have cut rates substantially

- Surprisingly, Non food credit and Exports growth do not show any clear relationship to a market breakout and in fact keep on deteriorating even as market makes higher tops.

If time permits, I will try and post detailed analysis around each of these variables separately and also some of my findings around the chronology of these events.

Amar Harolikar

Nice one Amar

Markets not yet tempting for the real 'Value Investors'.

Here's a graph I made 2 days back.

There is no reason for a value investor to look at the buying opportunities at current discounting of 17, they will start nibbling around 15 and become aggressive buyers below that i.e. 14-13, in the current scenario that gives us levels of below under 4200

Thanks

That's a useful chart. Would be interesting to see where the PE stabilizes this time around.

Sept'11 quarter was a 23% YOY drop in net profit in quarterlies. Another quarter of drop by even 15% in the Jan'12 results could probably push it towards the 15 PE zone much faster.

People bring in many more variable, like forward PE and growth parameters, but the historical PE is better and more stable parameter to time the buying for our core equity portfolio.

Buying @ average PE of 15 will give you min 15% growth compounded over a 3 year period horizon, now that's what history tells us, but the fear of "maybe this time is the exception" keeps many out of the markets until the time momentum is back and value is no more available

Thanks

Macro Technicals point to a possible bottom

The current state of macro and technical indicators point to an increasing probability of the markets being at the bottom or near a bottom. If I have to assign a subjective probability, I would say that theres a 60% chance that we have already touched the bottom. Of course that means that there is still a good 40% chance that a new bottom can be be made.

Key reasons why we could have probably bottomed out are:-

- falling monthly inflation number
- falling commodity prices
- possible bottoming out in US 10 year yields
- bullish divergences in MACD histograms in weekly and daily charts of Nifty

However, to get a better confirmation on bottom well need to see:-

- the monthly WPI inflation come down to 7% levels
- corporate profitability not getting any worse
- an uptrend starting in US Govt 10 Year yields
- bullish divergence in daily charts not being broken in next minor downtrend.

This part should will become clearer in another months time, by end of January 2012. If these bullish factors hold on for another month then very likely that a bottom has been made, and we then need to wait for the leading indicators for market breakout to turn green. However, If they break then the next stop is very likely to be Nifty levels of 4200.

Of course there could be shock events, either positive or negative, which could very well accelerate the move in either direction. Some examples of positive shocks :-$2 Trillion funding for EU , RBI rate drop by 200 BPS, Oil drop to $ 80, Rupee drops to $45 etc etc. Examples of negative shocks :- Greece defaults and exits, US Q4 GDP less than 1%, Italian / Spanish yields go above 10%, India GDP less than 6% etc etc.

Some more explanations below

In my previous analysis we looked at quarterly profits and monthly WPI as being the primary leading indicator for a market breakout. Variables like auto sales, US Govt 10 Year yields, commodity prices, gold prices, RBI rate cuts, advance tax estimates, IIP number and FII flows act as a secondary indicators to be used for confirmation.

- The very first indicator which reverses is the monthly WPI which shows a consistent drop to sub 5% YOY levels prior to a breakout. Monthly WPI has shown just a slight fall in Nov11. However trends in weekly WPI inflation, world food indices and global commodity indices indicate a sharp fall in monthly WPI over next few months.

- Global commodity prices are on a decline combined with lower WPI, will lead better corporate profitability in coming quarters. However commodity prices typically start to rise after touching a bottom, just prior to a breakout

- US 10 Year yields seem be forming a bottom, pointing to possible bottom in US equities too. Market breakout is typically preceded by a breakout in the yields, pointing to flow of funds to risky assets. Though, we would still need for the yields to rise before we can say that a breakout is near

- Rupee is not a major factor. A market bottom is typically preceded by a major fall in Rupee, however Rupee can continue to remain weak even as the market breaks out as long as quarterly profitability shows an improvement..

- From a technical perspective, the Weekly and Daily charts of Nifty are showing a bullish divergence in MACD histograms with prices making lower lows but the histograms making a higher low. This points to a possible bottom. However the key is that the bullish divergences should not get broken in the next minor downtrend. And if that is combined with markets making a higher low in the next minor downtrend, that will further increase the probability that a bottom has been formed.

By end of Jan 2012, well come to know whether the abovementioned bullish indicators hold up or get broken. If the bullish indicators get negated, then the next bottom is likely to be around Nifty levels of 4200 based on long term support levels. That would mean a correction of just around 35% from the last highs. 30% kind of corrections are very normal corrections during bull markets and have happened many times over and have lasted anywhere from six months to nearly four years for the 2000-01 dotcom bust/ Ketan Parikh scam.

Amar Harolikar