Either go long on IT sector or wait for now

Last Updated: Mon, Jan 14, 2013 05:31 hrs

On Friday, Information Technology (IT) was the only industry segment keeping the market afloat. Infosys made an astounding 17 per cent move and it was backed by large moves from TCS, HCL Tech, Wipro, and so on. Only 14 stocks out of the top 100 registered gains and seven of these were from the IT sector.

The CNXIT index rose an incredible nine per cent on Friday. One session, however strong, isn't enough to definitively call a sustainable uptrend. But this looks pretty solid. The sector has been an under-performer through 2012. The CNXIT index has registered only six per cent gain in the last 12 months, while the broad indices rose by 25 per cent or more. However, in the past four weeks, the IT sector has gained over 12 per cent. The sector was in the red, on a year-on-year basis, until Friday.

To a trend follower, half a dozen IT stocks now look to be worth tracking. It's a great pity that the sector index itself is very low liquidity and not convenient to trade. There are some points worth noting about a focus on IT stocks, including several purely technical ones.

One is that stocks that have made breakouts can correct back close to the point of the breakout before they shoot up again. This happens often. Any stop losses need to be set near or below the breakout point. So, given large moves on Friday, stop losses will have to be deep.

In terms of specifics, most stops would be somewhere near the respective price-lows of Friday so, we're talking of three-five per cent distance from current price in many cases. In Infy's case, I'm frankly unsure where one should set a stop loss but it would minimally be 8-10 per cent from money.

This brings us to a second technical point. Even trends as strong as this can fail. It would be sensible to take positions in several IT stocks, at the same time, or in staggered fashion as respective Q3 results come along. You don't know which breakouts will fail and which succeed.

It would be pragmatic to expect some trend-failures and also be prepared to take fairly large losses on those positions. Quite a few stocks in the IT sector can be traded via stock futures. The leverage will amplify violent moves. Expect losses on margined positions to hit 20-30 per cent of margin. The gains on winning positions would have to be commensurate or more.

The prudent trader might therefore, wait for a reaction before entering the IT sector. This reduces quanta of potential loss. But it would have a major opportunity cost if the stocks shot up some more instead of reacting. Either way – going long immediately, or waiting for a reaction, could work.

The strength of the move suggests that it will translate into at least a couple more uptrending sessions before the first serious correction. On the other hand, there will be a tendency to profit-book as well because the initial move was so large.

This brings us to the less technical considerations. The IT sector has been counter-cyclical through the past year, up to and including Friday. It also has a relationship with the USD-INR rate in that IT traditionally does better when the rupee is weak. However, that inverse correlation has been less in evidence in the recent past.

If it retains the counter-cyclical character, it's possible the rest of the market is due for a deep correction. A rupee drop could well trigger a sell off by FIIs or indeed, a rupee drop may be initiated by an FII sell off. These relationships may change but Infosys is basing at least part of its forecast on an assumption of the rupee not strengthening dramatically. So it's worth watching out for signs of weakness in the broader market and also, a falling rupee.

Finally, the Indian IT industry is cyclical in nature since business volumes is highly dependent on the US boom-bust cycles. If it is moving into a growth phase, chances are, there will be a pickup in other export-oriented sectors as well.

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