One of the questions that I have been asking myself is around mechanisms to identify signs pointing towards market corrections, in advance, such as the one that we are witnessing now, based on charts.
If you look at the NIFTY daily chart, there has been no warning as such (like a double top or consolidation pointing to distribution, before the ensuing correction, etc.); instead we observe an inverted V shape chart with a large correction in a short span of time, that has taken us by surprise.
One potential way is to look at index constituents which are heavyweights. The financial services sector forms 35% of NIFTY, of which the two HDFC’s contribute 15%. Reliance is of course an index heavyweight, with ~10% contribution.
Looking at the BANKNIFTY daily charts, it had formed a triple top and was not able to cross 28400 on three different occasions starting early August. This also pointed towards a distribution of bank/NBFC stocks, for most of August. In Elliott wave parlance, Wave 5 barely crossed Wave 3, which itself was an extension, pointing towards a subsequent steep correction.
Further, HDFCBANK forms ~35% of BANKNIFTY and has had a really good run over the last few months (close to doubled since early 2017 to August 2018). A correction was again due and some consolidation was seen here in August as well. But the BANKNIFTY chart topping out was the first warning; but the problem was NIFTY continued to climb upwards.
The up-move was driven by index heavyweights like Reliance, TCS and Infosys, all of which have a large contribution to NIFTY.
The second warning was the more or less one way upward move of Reliance stock from 1150 to 1329 during the month of August, with very little consolidation. This of course meant the probability of a correction was high given that Reliance is the single largest constituent of NIFTY. A steep up-move will more often than not result in a steep correction (due to stocks tendency to regress to the mean or the tendency of multiple moving averages over different timeframes to get together when separated significantly from each other)
In the Early part of the correction as well as in August, the IT pack started appreciating. This was because rupee had breached 70 for the first time against the dollar. This further gave the false impression of NIFTY not undergoing a correction in the near future.
However, the last week has been one of the worst weeks witnessed so far as even the IT stocks corrected steeply.
To summarise, what we can learn from the above analysis is to not only look at NIFTY charts but also focus on index heavyweights like BANKNIFTY/constituents and index heavyweights like Reliance, TCS and Infosys charts, to identify when a reversal is due. Looking at NIFTY charts alone may not give pointers towards ensuing market corrections. At the least, looking at BANKNIFTY chart is a must.