DON ratio is saying this: Enjoy the party, but stay close to the door
The drop in crude oil prices is good, yes, it is. But anything in excess is termed lethal.
But is this really a decoupled reaction, and a one-off? Or is there something hidden, like a mystery?
Through key statistical analysis, I have tried to put across a historically-proven data point, and how this can have a significant impact on Indian markets in 2019.
One of the ratios I have used is the Global Index Ratio, in our case, the DON Ratio (Dow-Nifty) ratio, and such other similar ratios for Bank Nifty-S&P etc.
Introduction: Just to make readers aware, there are three key aspects to the current market dynamics which are of ‘global significance.’
Point A: US Market Internals
The fall in the Dow Jones Transportation Average DJTA has been far more important than that of a fall in DJIA or Dow Jones Industrial Average. According to the classic Dow Tenets, the fall in the transportation index is more important than that of the industrials. This separates this correction from a ‘routine’ one.
POINT B: Is Europe the leader?
The other global point of concern is that history has indicated multiple times that the bigger global trend is determined by how European markets tick off. Multiple times over the past century, we have noticed that European indices have been leading the trend.
POINT C: Is excessive fall in crude price bad?
The drop in crude oil prices is good, yes, it is. But anything in excess is termed lethal like the case with steep rallies, and in many cases steep falls.
Crude oil has had periods of high correlation with equities, when it
goes into a vicious trend. From $85 to $55 (while writing this piece) and below, this crude price fall story is
getting muddier by the day.
In the backdrop of all of this, there are few important statistical ratios which I would want to highlight.
The Nifty-Dow ratio, Bank Nifty-S&P and Bank Nifty-Dow ratios. Readers who have followed my articles, or interviews on ETNOW, are fairly aware of these ratios.
However, for first-time readers let me give a small backdrop to these statistical parameters. This DON ratio compares the relative price strength of the US and that of Indian indices. They have shown strong periods of high correlation and mean reversion. The DON ratio at extremes indicates which asset class is undervalued or overvalued, and whether a process of mean reversion is likely to be in play in either, or both of them.
DON Ratio: Are we reaching the zone of outperformance?
The next ratios also exhibit a similar chart, but to a much ‘definite’ extreme.
Conclusion: All of the above indicates that the Indian indices are at a major resistance point (not just technically, but more statistically). And there is a very high probability that most of our indices are staring at a major correction.
We had already faced one such sharp fall a few months ago and also on Friday, and I am pretty sure investors have a sour taste of that till now.
Food for thought: Interestingly, two major corrections on the back of this ratio happened in 2010 and 2015. Both lasted almost a year. That could indicate that there is a four- year cycle going on for formation of TOPS. Read 2010 – 2015 – 2019?
Therefore, I think our current market situation may not be compared with that of 2008, but predominantly with a 2010 or a 2015 type of event.
However, correction even at those phases were both price wise and time wise. All said and done, the Bull Party may go on in the short term and, hence, my advice would clearly be:
“Enjoy the party, but stay close to the door.”