Political upheaval till elections 2019 offers an investment opportunity

In case of correction, long-term investors should increase their SIP allocations

Politics is likely to be the dominant concern for investors until May 2019. There are five assembly elections in the next four weeks and campaign fever will build up until the General Elections of April-May 2019. This will be a period of increasing volatility.

The macro-fundamentals look a little shaky. Geopolitical tensions are high. The World Bank has cut its estimates for 2019 global growth.  However, more than fundamentals, market returns in the next few months will be extremely volatile and very likely negative due to prospects of political change.

Suppose for example, investor consensus is that the current government is doing a good job. Then, there will be nervousness at the thought of a new formation coming to power. If consensus is that the current government is doing a bad job, there is nervousness at the thought it might retain power!  Opinion polls and assembly results might be inaccurate when it comes to predicting Lok Sabha results but these will influence market movements. Obviously, a war that affects crude prices, or a major terror attack, an assassination, etc., could change sentiment for the worse.

There are three major possibilities so far as the formation of the next Lok Sabha is concerned. One is that the current government will continue to be in charge, with policy continuity. The second possibility — and this seems the consensus opinion now — is that the BJP is unlikely to retain a majority, although it will very likely, be the single largest party. In that case, India is looking at a coalition which would work differently from the current presidential-style of governance. The third possibility is an entirely different coalition without the BJP. The fourth possibility — that any party other than the BJP can win a majority — is considered unlikely.

My guess is that the first three possibilities will be rehashed repeatedly in public discourse over the next seven months. The market will swing each time, but of course, it will swing in different directions depending on the news flow. The net effect is likely to be negative, with price corrections across the board. By the time of the Lok Sabha elections, the market is likely to be trading lower.

The second historical pattern is that the market generally recovers once there is a government in place, whatever that government might be. We’ve seen this, even with the ragtag coalitions of the late 1990s and we saw it in 2005-6 after the National Democratic Alliance was voted out. Fundamentals reassert their importance once political formations are known.

Let’s look at likely growth rates and valuations. Index valuations are still pretty high, with the Nifty trading at a price-to-earnings (PE) 25-26, while the Nifty Midcaps-250 is at PE 32-33 and the Smallcaps is at PE 63-64. Where the Nifty is concerned, there’s easily room for 25 per cent correction, to bring valuations back into the mean-median range of PE 19-20. Treasury yields are roughly in the 7-8 per cent range. If we’re comparing earnings growth to debt yields, we should be looking for valuations in the PE-14-15 range.  The Nifty rarely falls till those valuation levels but PE 17-18 does happen often enough.

An optimist would assume earnings for the Nifty basket at nominal Gross Domestic Product (GDP) growth (inflation + real GDP growth) plus some growth premium. Assume inflation stays at 4-5 per cent, GDP grows at 7.5 per cent (real) for 2018-19. The earnings per share (EPS) for the Nifty should grow at 13 per cent or better. The past two years have seen single-digit EPS growth but Q1 and Q2 suggested some acceleration is on the cards. Anyway, at an assumed EPS growth rate of 13 per cent and a PE of 20, the Nifty would be fair-value at roughly 9,400 by April 2019.

As an investor, anywhere in that 9,400-9,500 zone looks like a decent long-term investment. As any experienced investor knows, corrections can go a lot deeper than fair-value. While a long-term passive investor should continue averaging at current levels ignoring the political noise, he or she should increase equity commitments if the index falls below 9,500.

Technically speaking, corrections till 7,700-8,000 Nifty are quite possible.  Rather than panic, long-term investors should be increasing their systematic investment plan allocations if that does happen.  Look at political upheaval as an investment opportunity.