Where are IT stocks headed? Nasdaq trajectory has a story to tell

India’s primary strength in the global tech landscape has been its IT services sector. The Indian IT sector faced turbulence with IT companies underperforming in Q4FY23 due to factors such as delayed spending, fears of a global economic slowdown, and revised revenue guidance. But now there are indications of a recovery. The Nifty IT index, which had declined by 14 percent between April 1, 2022, and August 31, 2023, has shown signs of improvement since September 1, 2023, with a 4.11 percent increase.

One critical factor in this recovery is the reduction in attrition rates reported by IT companies during Q1FY24, signifying improved knowledge retention and cost savings from reduced employee turnover.

Furthermore, major Indian IT firms have secured multi-billion dollar IT services deals in recent months, bolstering their revenue prospects for the remainder of the year.

As we enter the second half of the year, several factors shed light on why the Indian IT sector is displaying signs of reversal and the potential beginning of a rally. Let us have a look at some of these factors.

A significant drop in US CPI Inflation may result in heightened interest in IT services, as businesses become more inclined to invest in technology and digital transformation endeavors. Consequently, this could contribute to improved profit margins for leading Indian IT companies.

The below chart illustrates a decade-long analysis of Nifty IT, showcasing a comparison between its returns in the first six months and the latter half of each calendar year. The IT index exhibited superior performance during the latter half in 7 out of 10 years. The average return in the first half of a calendar year from 2013 to 2022 is 3% and in the second half is 17%.The question arises: will this trend persist in the second half of the calendar year 2023?

The following chart depicts the performance of the Nifty IT index and the Nasdaq 100 index up to the present moment. These two indices have a correlation of 0.95 which suggests a strong positive linear relationship between them.

Currently, the Nifty IT index is underperforming or lagging behind the Nasdaq 100 index. As the Indian IT sector shows signs of recovery, it is reasonable to anticipate that the Nifty IT index will gradually converge towards the Nasdaq 100 index in the coming months.

The Nifty IT index is presently trading at a Price-to-Earnings (PE) ratio of 27, closely aligned with its 5-year average PE of 26. This figure is notably lower than its all-time high PE of 37.

Investors should focus on prominent Indian IT majors that are currently undervalued. As the index gains momentum, the companies with cheap valuations could spearhead the market rally.

Nifty moved in a higher high formation throughout the week and closed at 19,820, up 385 points. The Index is just 172 points away from the all-time high of 19,992, made on July 20. The Future Open Interest (OI) indicated a buildup of long positions in Nifty futures for all five days during the week.

The volatility cooled off in the current week as India VIX ended the week 5.15% lower at 10.78, giving major comfort to the bulls. The Foreign Portfolio Investors (FPIs) built long positions in Index Futures during the week as the Long-Short Ratio moved from 51.77% on 4th September to 56.89% on 7th September. Nifty consolidated in the 19,250-19,600 range for 24 trading sessions before breaking out of the range during the week and gave a higher close on the weekly chart for the first time in six weeks.

Nifty closed marginally below the 78% Fibonacci retracement level on 8th September, which is placed at 19,830 levels, drawn from the high of 19,992 made on July 20 to the low of 19,224 made on 31st August. Nifty looks poised to breach its all-time high of 19,992 soon. The level of 19,700 will act as immediate support for Nifty, being the maximum put open interest strike. This level presents a good opportunity to capitalize on potential market dips, should profit booking ensue from the prevailing levels in the forthcoming week.