The Looming Spectre of Stagflation in India

Originally published in The Financial Express, August 16, 2010.

Currently, the world equity markets are in an extremely fragile state. From a fundamental standpoint, the sovereign debt issue facing Europe has become an afterthought, but the problem has not been solved. Strengthening in the dollar will add to Europe’s woes as profits of multinational companies and GDPs will shrink.

The Indian equity markets are not immune to the movement of the indexes of other nations. We saw the effect of the world’s recession on the Nifty and Sensex in 2008. Even the Indian GDP dropped from 9.82% growth in 2006 to 5.7% in 2009. While there was continued growth in 2010 with the GDP rising to 8%, the forecast, moving forward calls for a slowing in that growth in India and the world.

Stagflation is a real issue facing India currently. Stagflation is an economic condition where there is slow economic growth, high unemployment which is accompanied by inflation. With decelerating GDP growth and double-digit inflation already a factor, the final portion to complete stagflation is a high unemployment rate. Currently, India’s unemployment rate stands at 10.7%, according to the CIA World Factbook. This represents approximately a 4% increase over 2009’s rate of 6.8%. Many will argue that India is not experiencing stagflation since the GDP growth is projected to hold steady at 8% or even climb to 9%. However, one must remember that prior to the credit crisis; the estimates for India’s GDP were much higher than the 5.7% that was realized.

From an equity market standpoint, stagflation isn’t pretty for passive investors. The experience of 2008 notwithstanding, the average investor could have made roughly 250% in the past ten years by simply tracking the Sensex. This has caused many to believe that by holding on to losing positions, or averaging down, one will eventually profit in the markets. In a stagflation environment, this is not the case. The passive investor will endure massive price swings that will try even the most patient and large accounts.

To understand where the Indian equity markets will most likely head for the next several years, I would like to look at the chart of another market that had entered into a stagflation environment. The chart shows a comparison of the Sensex from 2007 to present against the Dow Jones Industrial Average of the 1970s when the US was mired in stagflation. Notice the similarities in the Sensex to the Dow. The past price peaks and movement are nearly identical. Should the world enter what most economists are calling a “double dip” recession, we may very well see the same chart patterns play out for the Sensex and Nifty.

The Sensex and Nifty have been moving higher with less momentum as evidenced by lighter volume and technical indicators. This upward movement has peaked on the Sensex at 18,300. Looking to past demand levels and assisting my analysis with Fibonacci retracement tools, I am seeing several pausing points for the markets that will offer profit-taking opportunities for short sellers. The current drop in the markets should bounce at approximately 16,000 in fall (by winter) 2010 on the Sensex. This will test prior support areas, but will be below the bullish channel we are currently in. The break of that channel signals to technicians that weakness and fear has taken control of the markets.

A bear market rally that follows this drop will offer false hope to investors caught on the wrong side of the markets. Technical analysis is not just about analyzing price but also human emotions of fear and greed and their effects on price action. Once investors see the failure of their greed to push prices higher or even maintain the price channel, fear and a selloff of equities will follow. Again, this is not necessarily bad if you know how to protect yourself and/or profit from this move. Using the 1970s Dow as a benchmark, we should see a final bottom of the Sensex near 12,000 in early to mid-2011, a 61.8% retracement of the 2009-10 bull run.

The next several years of global economic rebuilding will cause many equity markets to move sideways in tight ranging channels as investors will be wary of entering into a false recovery. They experienced pain in the 2008 drop of stock prices and in the upcoming 2010 drop and will be less likely to buy into the markets until a strong bull market rally is well underway. The educated investor will be able to identify this bull market well before this point and, therefore, see much greater profits. Investors in the Dow Jones Industrial Average in the 1970s were stuck in a decade-long choppy, sideways movement that did not end until 1982 with the next great bull movement. India’s markets are moving much faster and should be able to emerge in a much shorter time, perhaps in less than six years. In the meantime, market timing and risk management will prevail.

We are sitting on the top of a precarious perch, perhaps looking at an amazing opportunity or a financial disaster. Your perspective depends on your education and skills in navigating the markets. Those who are educated in technical analysis and know how to practice proper risk management will prosper in the upcoming market swings. Those who ignore the warnings or blindly follow conventional wisdom will be doomed to repeat the past.

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