The Indian Stock Market Rally Is About To Be Seriously Tested

| About: WisdomTree India (EPI)
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Summary

The Indian stock market rallies in the expectation of a positive Union Budget on February 1.

Can the market rally further from here?

It can but investors should reduce some exposure before the big event.

In my previous article on the Indian stock market (BATS:INDA), I had contended that Nifty 50 (NASDAQ:INDY) could be preparing for a big bust if the index failed to hold on to the crucial support zone of 7910-7920. As we have seen, the index has respected this support zone once again and bounced more than 6 percent to scale 8400.

What next from here on? Should investors continue to remain long or reduce their exposure prior to Union Budget on February 1? Let us discuss.

From the daily Nifty 50 chart below, it is evident that the Indian market has broken the medium-term downtrend and is attempting to scale higher.

Much of this rally can be attributed to the positive expectations from the budget, which is likely to be a major event for the market. There are two cases to consider here.

If the budget is able to meet the expectations, it may be a sell-on-news event.

If the budget fails to meet expectations, we can see a sharp fall in the market in the absence of any positive trigger. Earnings are expected to remain depressed in Q4 as well following the demonetization move.

But, can the market rally further? Well, it sure can. There is no end to a rally based on hope and expectations. The market can easily rally 100-150 points from the current levels or it may turn on its head immediately.

I have employed the crucial technical indicator - Fibonacci retracements - to the entire downtrend from September to December. The market is currently hitting the 50 percent Fibonacci retracement level of 8430. It tried to cross this hurdle once on Jan 13 but failed. I would not be surprised if this resistance were crossed as soon as in the next trading session, with the market climbing higher.

What will be interesting to see is whether the bulls can muster up the courage and strength to cross the 61.8 percent Fibonacci retracement near 8550. The level of 8550 is of crucial importance also because the market had respected this level several times in the past, before it was finally violated days before the outcome of U.S. presidential elections. In technical analysis, a breached support is assumed as the resistance.

So, I strongly believe that the rally in Indian equities will be seriously tested before or on the day of the Union Budget (February 1). Based on positive expectations, the market can pierce the 50 percent Fibonacci retracement level near 8430 and race higher to 8550 which is the 61.8 percent Fibonacci retracement level. But, I doubt that the market can run any higher than that in the absence of any positive ammo from the budget or otherwise. Investors can choose to reduce their exposure before the budget announcement and re-enter when the market is inexpensive.

The reason why I suggest waiting for lower levels is not unfounded. I present a Nifty 50 PE chart spanning the period from 1999 to Friday 13, 2016. As you can see, the PE as on Friday's session stood at 22.47 while the median is 18.90.

Source: Historic-pe-ratio.weebly.com

Historically, whenever the market's PE has crossed the standard deviation of 22.5, it has failed to reward investors substantially, and sometimes, even brought them painful losses. On the contrary, when the investors have invested money closer to or lower than the market's median PE of 18.90, they have reaped huge returns.

So, what will you prefer? Investing at a low-risk level for high returns or at a high-risk level for low returns?

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.