Spotting market trends with Bollinger Bands

As announced earlier, I will be publishing market analysis using long-term technical indicators from the time to time. In the Oct. 2018 edition, we discussed if we are in a bear market. Have things changed now? Let us find out using the Bollinger Bands. They are easy to use and understand for investors to spot long-term market trends and plan their tactical asset allocation (TAA) strategy.

What is my aim with these posts?

It is one thing to look at technical indicators based on past data and conclude things and quite another to use them in real time. My aim is to find out how easy it is to do so in real time. My advice is to use these posts to explore this avenue and not commit actual money until you are comfortable. Different types of technical indicators should be used in combination and it takes some experience to interpret right with the clear understanding that things can go wrong.

Even if you do not want to use tactical asset allocation, you can use such long term indicators to get a “feel” of market trends. I would trust these more than the “experts” on TV and Twitter (especially the clowns with blue tick)

Spotting market trends with Bollinger Bands

What are Bollinger Bands?

They are a combination of trend and volatility indicators created by John Bollinger. Since there are plenty of resources for how traders can use it, let me define it for investors. The idea is to first plot the 200-day daily moving average (DMA) of the closing price of an index. For example this, the 200 DMA of the Nifty Midcap 150 index.

200 DMA of the Nifty Midcap 150 index

One way to “time” with 200 DMA is to keep investing systematically, sell equity if the price moves above 200 DMA and move to debt. If the price falls below 200, move back to equity. If you observe the chart closely, the price will (1) stay above the 200 DMA for months before falling and investors could miss out on growth and (2) the price can move above and below the 200 DMA in quick succession which makes it quite difficult and impractical to implement a TAA strategy. This is a backtest with a 10-month moving average which is a stable proxy for the 200 DMA. Market Timing With Ten Month Moving Average: Tactical Asset Allocation Backtest Part 2

Bollinger bands are two lines drawn above and below the 200 DMA. The bottom line or lower band as it is called is two moving standard deviations below the 200 DMA. The upper band is two standard deviations above the 200 DMA.

Illustration with Nifty Midcap 150

Bollinger Bands of the Nifty Midcap 150 index

Volatility indication The movement of these two bands can indicate market volatility. If the bands come together, the volatility is low and if they move apart the volatility is high. This alone is not sufficient for TAA.

When the upper and lower bands converge with the 200dma moving up, it could mean bullish trend (red circles above). When the upper and lower bands converge with the 200 DMA moving down, then it could indicate a bearish trend.

Buy/sell indication With the bands reasonably spaced apart, if the price hits the upper band, it could mean an overheated market and a sell indication. You can see instances of that above. That is a bearish market outlook. With the bands spaced reasonably apart, if the price hits the lower band, it could mean a buy indication.

This is a closer look.

Closer look for NIfty Midcap 150 Bollinger bands

Are we now in a bearish trend wrt midcaps? Probably. We need support from other indicators (see Oct 2018 post linked above) or wait a bit. Plotted below is the 10Y average of the NIfty Midcap 150 PE. The window available is quite short but within that, the long-term Midcap PE seems to be coming down and that is a good sign with room for further correction.

PE long term average of Nifty Midcap 150

Nifty Next 50

The red circles indicate price moving up with low volatility (possibly bullish) and blue circles indicate price moving up with high volatility (possibly bearish)

Bollinger bands for Nifty Next 50

Currently, the NN50 bands are tending close to each other with the price hovering below the lower band.

Closer look of Nifty Next 50

Again it looks bearish for Nifty Next 50, but one indicator alone is not enough. This is the 5-year rolling PE average of the Nifty Next 50 (I could not plot the 10Y average, the sheet misbehaved)

Nifty Next 50 5-year PE average

Current NN50 PE is two standard deviations above the 5Y average. SO if we go by what goes up must come down, there is plenty of scope for PE to fall.

Nifty 50

Nifty 50 Bollinger bands

If you compare the recent band movement for Nifty 50 with Nifty Next 50 and Nifty Midcap 150, notice that the large-cap volatility has not come down as much and the price has quickly shot up from the lower band.

Nifty 50 closer look of the Bollinger bands

This is the 5-Y rolling PE average of the Nifty 50

5-Y rolling PE average of the Nifty 50

The reason why investors prefer the Nifty PE to other index PEs is that each time the current PE hits the long term (5Y or 10Y) average + 2 std dev band, the market tends to correct (sometimes briefly) as in the recent past.

Summary

The large cap (N50) charts do not indicate either an upward or downward movement as of now. The mid cap charts (NN50 and Midcap 150) suggest a narrowing of the Bollinger bands with the price trending down or flat. If it the 200 DMA moves down with narrowing of bands then it probably means more fall in price and if it moves up with a narrowing, it could mean an increase.

More often than not, things will not be as clear in real time as they look in hindsight. There are only two options. Get used to it, form opinions and go with them or avoid this altogether.

The fall in oil prices has helped hold the market up but for how long? With an election just months away things can change pretty fast.I have said this several times before. I think the market has buoyed up more by sentiments than real earnings for the last 10 years (probably things got a bit better recently). This party may not last long. As of now, it is hard to say one thing or another.

What should I do?

When the market fall sharply a couple of month ago, I decided to do nothing. As of now, that is my stance. If you are a young investors, invest more! If your goals are 10+ years away, you do not have to worry about this now. If your goals are close, then you should be pulling out of equity anyway.

The real problem is only for those who sitting on cash waiting for a fall. My suggestion is to gradually push that money into the market (with an asset allocation) and be ready to pull out later as discussed here: Want to time the market? Then do it right! Buying on dips is not timing

Always keep in mind that different types of indicators should be used if you want to “time”. I have used volatility + momentum + valuation. There are other types as discussed here: Are we now in a bear market? Market Analysis (October 2018)

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