Wait for elections before putting fresh money in equities

It's been a reasonable year for Indian index investors. Since January, the Nifty-Sensex pair have returned a little over 6 per cent in rupee terms. This is an under-performance compared to inflation but it is nominally positive. A positive return of any kind seems paradoxical on some counts.

First, the Indian investor - institutional and retail - has been bearish. Mutual funds have seen net redemptions through 2013. Domestic institutions have been net sellers of over Rs 72,500 crore since January. The major market indices have risen purely on the basis of support from foreign institutional investors. The FIIs have pumped a net Rs 86,679 crore into Indian equities in 2013. The FIIs have lost money overall. Due to the weak rupee, the Nifty is down about 5 per cent in USD-denominated terms.

The Indian economy has shown a GDP growth rate of somewhere between 4.5 and 4.8 per cent in rupee terms, if one uses the wholesale price index as the deflator. It has shrunk in USD terms. If you use the consumer price index as a deflator, the Indian economy has stagnated.

This highlights how high consumer inflation has run and how much the rupee has fallen. The currency weakness also lays focus on the massive Current Account Deficit. The

CAD will shrink in 2013-14 because the weakened rupee has helped exports to pick up. But it will still remain at dangerously high levels.

The bull run has to be seen in the context of equity markets discounting future expectations. It cannot be justified by growth in 2012-13 when earnings growth (nominal) has been 10 per cent or less. Investors are taking a massive gamble in hoping that first, there will be a clear verdict in favour of the BJP/ NDA and second, such a verdict will enable positive change.

This political outcome may or may not come about. The current policy logjam could continue through 2014, if there is another fragile coalition, or a hung Parliament. Even if the BJP does gain a clear mandate, it is perfectly possible that it will fail to meet expectations.

Consider buying equity purely as a bet with a risk and reward equation. If there is an improvement in governance, or at least some increase in economic activity, the investor will gain through 2014 and beyond. If there is no such improvement, the investor may have to accept capital losses for several years.

How much can be gained versus how much can be lost? Well, the major Indian indices are trading at PE18-19 (last four quarters earnings). This is on the high side historically. But enormous financial resources could come into the equity market if domestic sentiment turns around. So there may be a big upside.

If earnings growth does accelerate and sentiment improves, we could perhaps, see a doubling of equity values from here over the next two years. Let's say the potential for 100 per cent capital gains over the next 24 months exists, implying a Sensex/ Nifty valuation of around 42,000 or 12,500 respectively by late 2015.

On the downside, if domestic sentiment doesn't turnaround, and FIIs decide they are tired of waiting, the market could nosedive. The indices could lose between a third to half of current values over the next year, if the election results are not to investors' tastes.

Very broadly, therefore, the market could gain 100 per cent over two years or it could lose 50 per cent within a year.

If these two events had the same probability, this bet would favour the bulls.

The return to risk equation would be something like 2:1 in the bull's favour assuming the events were equal probability.

However, these two events are not the same probability. They depend on electoral results. Since 1989, no party has won a clear verdict in general elections. This suggests that the chances of the BJP/NDA winning the sort of verdict that will make the market happy are not very high.

When you take a bet, you multiply the potential gain and loss by the probability of respective outcomes. Since the probability of a solid majority for the BJP seems rather low, the reward for going long also seems somewhat low to me.

But of course, this may be a historic "Black Swan" election when the BJP wins a huge majority.

If that happens, the investor would probably still have time to catch up. Don't commit too much in the way of extra resources to the equity markets until there's some clarity on the electoral front.