An election strategy

In the next two months, an election panic could offer good opportunities to buy.

Risk analysis often starts with an assumption that price changes are normally distributed. This is a convenient fiction. Normal distributions are well understood and easy to work with. About half the values will lie above, and half below, the average.

Roughly two-thirds of values will fall within one standard deviation of average (average +/- 1 SD), 95 per cent within two standard deviations (average+/1 2SD), and 99.7 per cent within three standard deviations (average+/- 3 SD).

If all this is true, it's possible to trade with accurate estimates of potential gains or losses. However, problems arise because price changes aren't truly normally distributed. The danger zone lies beyond average +/-3SD. Prices move beyond the average +/- 3SD zone far more often than the expected 0.3 per cent.

Look at daily price changes in the 3,778 Nifty sessions since January 1994. Price swings beyond the +5.6 and - 5.12.per cent level (the average +/- 3SD) would be expected to occur only 13 times. In fact, prices swung more than that in as many as 63 sessions. What is more, prices moved beyond 10 per cent thrice (twice falling by 12 per cent), and beyond 6 per cent on 28 occasions.

Many of those big swings occurred during times of political instability. India has seen four general elections between 1996-2004 and each contributed several big movements. In addition, there was high volatility when various governments were perceived to be unstable. The net effect of election periods was bearish with the exception of 1999.

This bearish association is not irrational. India is still a policy-driven, command economy. Political instability has big fundamental impacts. A change in government usually means significant policy changes and instability can translate into abysmal rather than merely poor, quality of governance.

Nevertheless, each of these bearish periods presented great investment opportunities for patient long-term investors. In hindsight, we see that prices always recovered handsomely. In the worst case scenarios, it took no more than 3 years to generate outstanding returns. Usually it took much less time with prices making some recovery within two months of a new government.

Is there any reason why the 2009 elections will have a different effect on the market? Political instability during and immediately after the elections is a given. Deep into global recession, India desperately needs competent governance and sensible policy-making.

Moreover, the market is already down almost 50 per cent from its January 2008 highs. The bearish long-term trend makes it more likely the elections will trigger a key bear-market bottom. A temporary drop of another 15-20 per cent would make valuations more attractive and turbo-charge potential long-term returns.

The 2009 elections could therefore present an excellent opportunity to buy. There are some caveats. The first is that, if a stable but markedly incompetent government comes to power, the economic recovery will be retarded. That would mean an extension of the holding period for investments.

The second danger is that an investor will be unable to optimise the prices at which he or she buys during a period of high volatility. The practical way around this is to buy in staggered fashion. That way, even if some orders are placed high and some low, the average prices will be acceptable.

The ideal situation for an investor would start with an election that triggers panic and a 20-30 per cent drop in prices. It would evolve with the formation of a reasonably stable and competent coalition. That combination of uncertain election and eventually stable government would lead to a v-shaped price recovery from the election trough. This is what happened in 2004.

If such a situation occurs, you would want to buy very heavily during the election period. You may also want to put together hedges in the form of long puts. That is optional. Either way, it’s time to put together a war-chest to be invested over the next two months.

Don't waste energy stock picking in such circumstances. It is far more important to get broad asset allocation right. Ensure that a significant share of your investment corpus is in equity rather than worrying about the specific stock to buy. Buy the broad market indices via index funds or buy pivotals or buy specific stocks you fancy. Just make sure you don't miss the opportunity.