Another election strategy

The General Election results will be declared this week. Last week, we considered some short-term trading ideas that could gain during the churn as a new government takes over. What little we have in the way of data and anecdotes suggests that there could be considerable uncertainty for a while with a fractured mandate.

That could mean months of volatility. Last week, I had outlined the use of index options under the assumption that the Nifty (and Nifty Bank) could swing 5 per cent or more by May 30. It is not unlikely that volatility will continue into June, especially if there’s a rainbow coalition. Traders could therefore, consider option trades to bet on index swings of 5 per cent or more through June.

Let’s consider the longer term and the broader picture. Economic conditions are deteriorating globally and the Indian economy is struggling to maintain growth momentum. Given trade war, US tensions with Iran, Brexit chaos, and so on, things could get worse globally.

India could gain from this situation if, for example, MNC manufacturing shifts out of China to India to escape tariff punishment. It could also gain, if Foreign Portfolio Inverstors (FPIs) decide that India retains better growth prospects than other Emerging Markets. Those are long-shots. India doesn’t have a competitive domestic manufacturing environment. Corporate results don’t show major signs of revival. Indeed, things may be getting worse, if we examine the slowdown in high-speed data and sub-par monsoon prospects.  

Whatever government comes to power, it is committed to some populist spending. So be prepared for further deterioration in public finances. At the same time, that government will have to look at a review of Goods and Services Tax (GST) processes and tax rates, and of the Insolvency and Bankruptcy Code (IBC). It will have to reform the entire data-collection and dissemination process, which has been completely debilitated. The BJP would be reluctant to do these things. This is why a coalition, which is not led by the BJP, has a better chance of triggering an early economic revival.

Stock market valuations are way higher than can be justified by any metric based on either growth, or value. The debt market is shaky due to all the defaults that have occurred within the last 18 months. Corporates will be crowded out of the bond market by government borrowing to meet a huge fiscal deficit.

It would be sensible to expect a crash and to be braced for it. This doesn’t mean that you should sell off your entire portfolio and exit equity. If you are a stock picker, take a look at your equity holdings and run a thought experiment: How many of these stocks will you be comfortable holding if the market value of the stock falls by 35-50 per cent? How many of these stocks would you be comfortable holding for the next three years?

Book profits in the stocks that you aren’t comfortable about and park some of those funds in gold as the safest of assets in a crisis. Hold the rest of your portfolio.  Look to increase your commitment to anything that you’re prepared to hold.  If the prices of the stocks you like fall, average down.  

If you are a systematic passive investor with an equity mutual fund portfolio, you also need to increase exposure as the market drops. One approach is a martingale. Raise your monthly commitments by 10 per cent if the market drops 10 per cent. Or raise commitments by 10 per cent if the market falls 20 per cent – the principle remains the same.

Indian bear markets can be quite vicious. But they are also of relatively short-duration. We’ve seen several periods when the indices have lost 50 per cent in a 12-month period. But there has rarely been a three-year period when indices have not made net gains.  If there is a bear-market, keep that cyclical pattern in mind.

In terms of valuations, there is a tipping point when equity becomes a safe investment. The Nifty has an average valuation in the price-to earnings (PE) ratio of 18-19 range – both median and mean values fall in that zone. It’s at PE 25-plus now, after a 3 per cent correction.

If the market drops below PE 18, that is, roughly 35 per cent off peak values, be prepared to buy heavily into index assets. A bounce-back is guaranteed and it’s highly probable that you’ll make a 50 per cent return within a couple of years.