Why you should avoid financial stocks in this bear market ?

Nifty took support around 7500 and has bounced back to 9000 levels. One sector which clearly shows leadership is pharma. You can read my post here. 

As Warren Buffet mentions, there are 2 main rules one should follow in stock market:

Rule 1: Never lose money
Rule 2: Never forget Rule #1

So I think it is also very important to identify the sector which we should stay away from. Why ? Because thats where maximum pain would be and even with the recovery chances of making money in near term are less.That sector is Financials.

Financials had weightage of ~37% in Nifty which shows huge ownership. They were the leaders of bull market and have shown meteoric rise for more than 10 years. And now with a major fall, its likely that there will be a sector rotation i.e. money will move out of this secotr into other sector. There is an old adage that "Leader of previous bull market rarely come back". This is because due to sudden collapse in prices, there are many investors who are left holding these stocks just to get out at break even prices. During each rally, there are such sellers who get out creating pressure on prices. Also there are bottom fishers who play for a bounce and at each bounce they create additional selling pressure due to profit booking. 

Currently the maximum pain that will be felt due to lockdown is in financials as there will be large number of defaults that are looming.

Now most of these stocks are exhibiting what we can call a bearish pennant or a bearish flag pattern. You can read about it here.

Lets try to understand the psychology about why this pattern is formed and the resultant move. Read below post from the link I've mentioned.

Psychology behind bearish pennant formation

Thus this is a reason why leader of previous bull market rarely forms a new trend.

Now lets look at charts of some of these stocks where you will clearly understand the weakness and how almost all of them are exhibiting bearish pennant formation signalling significant downside ahead. Key is to look at the slope of the lower trendline. This indicates whether there has been any bounce with Nifty rallying 20% from lows. Lower the slope, weaker the stock is. 

Bank Nifty

Major reason why Nifty today is at 9000 and not 10000 is because of Bank Nifty. It has fallen the hardest and as can be seen in the chart is not even retracing 38% of the entire fall. Thats a major sign of weakness.

Bajaj Finance

Bajaj Finance was the leader of the pack and has fallen from 4800 to 2100 ! During last 1 month's upmove in Nifty, it has hovered around this level and has touched the lower base 6 times. Each time is rebounded except today viz. 21st Apr and it closed around days low ! 1900-2100 is a major support for Bajaj Finance and with its break it will be a major fall ahead for the stock.

Kotak Bank

Same story here, breaking down from a rising wedge.

IndusInd Bank

RBL Bank

IndusInd and RBL Bank have been weakest of the lot. They have corrected significantly in wave 1 itself. 

Many of the funds and PMS have been hiding behind financials which helped them achieve strong performance. And with that hiding place crumbling, it will lead to more redemption pressure on these funds thereby leading to more selling of these financials thus creating a spiral. Interesting times ahead.

Will Pharma lead the next bull run ?

From stock market participants, currently there are 2 million dollar questions:

1. Where will the market bottom ?
2. Which sector will be leader of next bull run ?

I have already covered the first one in my earlier blog post. You can read the same here.

Now lets try to find out the leader of next bull market. What are few traits which one can look at while identifying a leader ?

1. Sector should be under owned
2. Price action should display leadership

Lot many try to focus on fundamentals which at bottom will always be negative. Always remember: "Price follows first, reasons follow later"

Looking at these traits, one sector which seems poised for a bull run is Pharma sector.

Let us try to analyze the reasons one by one:

CNX Pharma index: This is the sector index for Pharma. Look at the weekly chart. This sector was in a bull run since 2009 and topped out in 2015. Since then it has been in a bear market for 5 years and has seen multiple rallies only to make a new low each time. This is a typical Lower High Lower Low pattern exhibited in a bear market. What does it do ? Each time folks see a rally, they try to get expecting resumption of a bull market only to be disappointed each time. What happens when such an event plays out over 5 years period ? People get fed up. This leads to under ownership of the sector. You would hardly see new funds being launched by AMC's which also signify that there is serious lack of interest. Nifty pharma weightage in Nifty is 2% compared to 36% for Financials !! This all points out to under ownership of the sector.

CNX Pharma

Look at how the price has been correcting below this sloping trendline. A close above this line will also lead to break in Lower high Lower low pattern thus indicating end of bear market. Currently entire world is focusing on de-risking from China and Indian pharma would be a major beneficiary of this move.

Now whenever a sector which has seen a bear market for 5 years starts rising, one thing we see is the old leader get selling pressure a higher levels. Why ? There are many so called long term investors who are stuck at higher levels and are holding these stocks waiting for a day they can get out once their investment breaks even (they hate getting out at a loss without realizing that they have faced huge losses on account of opportunity cost) . Due to this there is a strong possibility of new leader emerging in this sector and old leader under-performing. How do I know ? Well the price actions is saying so.

How do you identify leadership ? Best way in my opinion is to look at stocks which don't significantly correct in bear market and lead the charge during bounce back.

Few leader below looking at price action. (comments are present on chart)

Torrent Pharma

Biocon

Divis

IPCA Labs

Granules

Now lets look at some of the old leader and you can see why chances of these giving multibagger returns are less. Of the lot I find Dr Reddys to be the strongest which has clearly bottomed out. The other are yet to establish a clear trend

Dr Reddy's

Sun Pharma

Cadila

Cipla

I think the key to make money here is to look at how these stocks react when the market corrects again and when there is a rebound. For those who don't want to be stock specific, buying a pharma fund or a basket of above stocks is also a good idea.

Disclosure: I am not a SEBI registered investment advisor. The content in this blog are academic in nature, please consult your investment advisor before taking any investment decision; I may have position in stocks discussed on the blog