Share prices will drop further

Equity investors should increase allocations on every significant correction

The Budget was a somewhat uninspiring document. It raised tax rates only by moderate amounts. But the revenue assumptions appear highly optimistic and the subsidy estimates appear unrealistically low. Nor do the policy changes seem designed to inspire a broad-based turnaround.

It seems the Finance Minister is hoping that the economy will make a cyclical turnaround, with growth rebounding, more or less of its own accord. It may happen. But the government could have done more to help the process along.

The one enabling factor in a trend reversal may be falling interest rates. But that is in the purview of the Reserve Bank of India, rather than the Finance Ministry.

So, what does a committed investor do under these circumstances? The market has seen an adverse reaction with a sell-off. But that shouldn't influence a long-term investor too unfavourably. The Indian market was over-valued going into the Budget and the reaction was driven to a certain extent by factors that had little to do with the actual Budget.

On the domestic front, there have been recent margin calls in the mid-caps with at least one major operator going bust. Several high-volume mid-caps stocks have hit a continuous series of lower circuits and leveraged positions have also been forcibly liquidated. Apart from the mid-cap mayhem, long operators who were over-optimistic about the Budget have cut their losses.

The other factors causing bearish sentiment include uncertainty in the US and in Europe. The Italian election has made traders nervous about the already troubled European Union. Italy is a big economy and if it's rudderless, or it rejects fiscal prudence, it could cause further stress to the entire zone.

In the US, it appears automatic spending cuts will be triggered. That could mean a slowdown in the world's largest economy, where growth is increasing slowly. Foreign Institutional Investors will wait for clarity on these issues and reconsider their options and re-weight their portfolio allocations according to developments.

It is likely, however, that shareprices will drop further. The Budget failed to impress on the growth front and there's no compelling reason to increase equity allocations immediately. The problems referred to above will lead to at least a temporary drawdown in liquidity.

In fundamental terms, a continuing correction may bring valuations back to reasonable levels where investors are prepared to build portfolios for the long-term. After the correction in the Budget session, the Nifty is trading at a PE of 17.5-18. A domestic retail investor can get a 7 per cent return from low-risk bank fixed deposits. A domestic institution can get 8 per cent yields on government paper.

As these variables change, so will investor perceptions of valuations. Earnings estimates aren't strong in the short-term. The hike in corporate tax rates will retard net profit a little as well. However, policy interest rates are likely to come down over the next year. Treasury yields will drop and banks will also lower both savings and FD rates as soon as they can.

Let's say EPS for the Nifty group of big stocks will grow at 12 -13 per cent, while the FD rate will drop by about 100 basis points over the next six months. At a risk-free rate of 7 per cent, a PE of 14-15 is full-value, since a PE of 14 is equivalent to an earnings yield of about 7 per cent.

At an interest rate of 6 per cent, the fully-valued PE ratio is 16-17. A PEG ratio of 1 would translate to PE 12-13. Factoring in growth, and leaving a margin of error, the Nifty would look attractive if it was available at PEs of below 15. To reaching those values would imply a further correction of Nifty 300-500 points over the next six months, pulling the index down to, say, 5,400 or lower.

It's not an impossible scenario by any means. The market has been pushed up over the past 18 months purely by FII action. A slowdown in their India-allocations could be enough to push the market down to those levels.

If they start selling in quantity, it could trigger off a much deeper correction since Domestic Institutional Investors and Indian retail lack the monetary resources to shore up the market.

Politically speaking, there will be no clarity about long-term policy direction until the next government takes charge in mid 2014. In macro-economic terms, the rebound is likely to be slow in 2013-14, even if the Budget estimates are met.

In the circumstances, the best option for an equity investor may be to leverage down, increasing equity allocations on every significant correction. Below 5,500, the Nifty approaches fair-value. Below 5,000, it becomes attractive.