Equity Ooutlook: Higher chances of a correction only after election results

The pre-election rally has given a 10 per cent upswing in the NSE Nifty in the past two months, with foreign institutional investors (FIIs) buying stocks worth $4.3 billion. With this, they balanced their portfolios, selling heavily overweight positions in the export-oriented (information technology and pharmaceutical) and consumer sectors, while buying financials, capital goods and global cyclicals. With emerging market (EM) fund flows reversing in two months, it has resulted in positive flows into India. The impact of sharp market rallies, following the previous two election results, still haunts many investors caught on the wrong foot and, hence have, over the past three months, switched to a market neutral portfolio.

Domestic institutional investors (DIIs) followed a similar portfolio rebalance. The only difference being, domestic mutual funds continued to get redemptions, and hence, sold stocks worth $4 billion. We believe the balancing of the portfolios is over and the market will now continue to trade in a narrow band, with limited upside or downside till the announcement of election results.

As a result, the IT sector Nifty weight fell from 19 per cent in February 2014 to 15.7 per cent (340 basis points), compensated by a 230 basis points expansion in Nifty of the financial sector. Within this sector, public sector banks outperformed the Nifty by 32 per cent while the Bank Nifty outperformed by 25 per cent. Yet, the banks seem to have underperformed if we take a one-year period. We have observed small increases in weights in capital goods, petrochemicals and metals (global cyclical).

Currently, the market trades near its average price to equity (P/E) multiples and hence, may reflect that there is still some steam left. However, having said we are getting into some headwinds, the first, and foremost being the outcome of the election results. While opinion polls favour a strong National Democratic Alliance coalition, the actual results are still not out. There is a possibility there could be a slip between the cup and the lip. The second, is the forecast of a below average monsoon and the third, the very bullish view of the market observers. Interest rates have remained elevated as the 10-year benchmark hovers around nine per cent and the currency has begun depreciating. The huge inflow of short-term FII debt, very high two months ago, is now getting withdrawn. Such withdrawals have accelerated in the past 15 days.

The market now factors NDA to form the government with seats in excess of 250 (272+ is required for majority). Anything below 230 seats may lead to a sharp correction in the market, led by financials, capital goods and cyclicals. Hence, it will pay to remain benchmarked to the market weights.

The derivative market is very interesting. While open interest in both the stock futures and index futures are not heavy, the long open interest is primarily directional and the corresponding short is from the arbitrageurs. Over the past one month, we have observed the arbitrageurs have built fresh positions. Above 80 per cent of the stocks in the Nifty, BSE200 and BSE500 are trading above their 200 DMAs (Day Moving Averages), signalling a very bullish undertone. In the previous five years, we have observed that when more than 80 per cent of the market trades above 200 DMAs, a sharper correction becomes overdue.

Hence, there are higher chances of a correction in the market after the election results (unless, of course, the NDA gets a clear majority) and financials, capital goods and cyclicals look worst positioned, while IT, pharma and some consumer names look attractive.

The author is head, institutional equities, IDFC Securities