Quo vadis equities?

After a particularly volatile September, when the Nifty traversed as much as 774 points between trough and peak, investors are justifiably anxious about the possible course of the market over the next few months. It is useful to recall that the Nifty is just about five per cent below its all-time high in January 2008 despite the overwhelming sense of gloom on the economy.

A simple framework to evaluate equity markets is to analyse the underlying fundamental drivers, namely, interest rates, earnings, valuations and liquidity. Given the inflation fighting stance of the Reserve Bank of India (RBI), further interest rate rises appear to be in the offing. This cannot be good news for equities because from a valuation perspective, future cash flows would need to be discounted at higher rates.

Prolonged government indecision on an array of stalled projects in the infrastructure, power, mining, metals, real estate and other sectors, the apparently unjustified mega tax claims on companies and softening consumer demand have started showing in most economic indicators, as also the heightened level of stressed assets in banks. Even if all the roadblocks for investment are now cleared in one swoop, the investment pipeline - barring the myriad stalled projects - is near empty, evidently chastened by the recent experience of entrepreneurs in getting projects off the ground.

This puts paid to any great hope on earnings growth, at least for the near term. A vibrant economy led by new investments and burgeoning consumer demand is what gives companies their pricing power and hence potential earnings growth. The argument that valuations are reasonable at less than 15 times the current year earnings based on historic averages appears flawed in the context of the rather bleak earnings outlook for the next couple of years. That leaves liquidity - largely a function of foreign portfolio inflows - as the only potential driver of equity markets. Aggressive monetary easing in the developed world since late 2008 has been the main driver of foreign institutional investor (FII) inflows of nearly $85 billion since 2009. It appears likely that the US quantitative easing programme will be tapered over the next few months. Hence on a fundamental basis, there does not appear to be a case for a big up-move in the market.

What can change this view? With just a few months left for the general elections, the government machinery seems to be moving towards clearing the several roadblocks to investment. A strong agricultural growth coupled with some signs of a stabilising rupee and a possible reining in of the twin deficits also offer some hope for better times ahead. The big hope that can enthuse markets, however, is the prospect of a clear mandate for a strong government - of whatever hue - in 2014, which can rekindle the animal spirits of entrepreneurs. In such an eventuality, experience suggests portfolio inflows will not be found wanting and a virtuous cycle of new investments, rising demand, robust economic growth, all-round prosperity and increased savings leading to further investment is entirely possible. Meanwhile, let's brace for heightened volatility and interesting times ahead as the run-up to the general elections and the impending US taper are bound to generate many surprises on the way. Investors are best advised to look for any steep market corrections to re-build their fractured equity portfolios.

The author is director, Dalton Capital Advisors (India)