Post-election strategies

If there is a severe correction, the long-term investor could enter with a shotgun approach and buy the index.

Since March, FIIs have been net buyers of close to Rs 11,000 crore of Indian equity. After cancelling out Rs 7,000-odd crore worth of FII net sales in January and February, the net 2009 buying of Rs 4,000 crore is relatively small, compared to net sales of Rs 53,000 crore in 2008.

Nevertheless, Rs 4,000 crore is substantial and reflects a surprisingly positive attitude. Many advisories continue to be neutral or negative with respect to India. There are several ways to try and explain this dichotomy of verbal caution on the one hand and strong buying on the other.

The most cynical explanation is that a large portion of this Rs 11,000 crore is hawala money round-tripping back. Post election, the best-placed coalition will need to buy the support of 75-120 MPs. Post-election horse-trading will require deploying large unaccounted sums. Until it is required, that money may as well sit in the stock market especially since the most convenient way to bring it back to India is via equity.

A less cynical explanation is that portfolio investors are now correcting for excessive pessimism in 2008. Many FIIs benchmark their portfolios to emerging market indices such as the standard Morgan Stanley EMI. In 2008, some became severely under-weight on India. This buying could be an attempt to pull portfolios back in line with the MSCI's country weights.

This theory can be backed up by some evidence because many FIIs are under-weight. If it is true, the buying will continue, assuming elections don't throw up stunning surprises. Undoubtedly India is also one of the bigger beneficiaries of the bounce across global markets. There is also surely, a hedge fund component in that Rs 11,000 crore.

There is probably some truth to each of these theories. Some post-election funding is being parked short-term. There is also some buying triggered by FIIs trying to correct severe under-weightage. And some proportion of the cash is coming from hedge funds riding the wave.

But we don't know the proportions and the proportions are key to medium-term market direction. If the proportion of election money is high, the rally has a sell-by date and there will be a severe correction in store by end-May.

If the proportion of long-term FII flows is high, the rally will continue even with hiccups. Some FIIs seem to believe that this is likely. BNP Paribas for example, now has a calendar-year-end target of Sensex 15,000, which means expectations of 25 per cent upside from here.

However, other FIIs see a 15-25 per cent downwards correction from current levels. The conservatives assume that the bear market hasn't played out. In that case, the market will lose much of the 45 per cent it has gained since early March.

The long-term investor should be hoping for a serious correction. The rally has pushed broad market valuations up to uncomfortable levels. In terms of comparatives, Indian equity is trading at 16+ price earnings and this is markedly higher than other emerging markets. It can't be justified by the projected 2009-10 earnings growth.

It may perhaps be justified by the anticipated 2010-11 earnings growth but that is a long way down the line. Certainly, prospects 12-18 months down the line look reasonable. But there could be further pain and turmoil across the global economy in the short term.

There is general consensus that the October 2008 lows of 2250 will not be broken even if there's a drastic correction. This is a reasonable assumption. The October 2008 lows represented valuations in the range of 10-11 PE and India's broad market valuation rarely drops to single-digit PEs and it never stays at single-digits for long periods.

If there is a severe correction, the long-term investor could enter with a shotgun approach and buy the index. If the next correction is not that severe, then sector and stock-picking skills would come into play.

The conservative would seek businesses that have been beaten down the most. The aggressive approach is to pick businesses with the strongest 1-2 year growth prospects. An additional layer of safety would come to those who can mirror and second-guess FII portfolio selection. It's not that their stock-picking skills are extraordinary. But their relatively deep pockets provide a cushion.