A slugfest is on the anvil

MARKET INSIGHT: Nifty is still over-valued, expect some more correction.

When a financial instrument is wildly over or under valued, it doesn't take rocket science to flag imperfections in the pricing. It is just a question of comparing potential returns to the risk-free rate and applying the concept of risk and reward.

An acquaintance with the Capital Asset Pricing Model and a couple of back-of-the-envelope calculations is usually enough to work out when a stock is very cheap or very expensive. It's trickier when valuations and price are within touching distance "� in that case, one analyst's "fully-valued" may be another analyst's version of "under-valued".

Now for arguments' sake, one may concede that most of the traders in any given market are fools but the bulk of the money is controlled by people who are not. And it isn't the number of traders in play that moves stock prices, it's the amount of money in play.

Most analyst-estimates revolve within a relatively narrow band of expectations. Therefore, given that the moneybags are in rational hands and aware of the nuances of valuation, prices should also swing within a narrow band.

That, however, is manifestly not the case. Why do stock prices swing so wildly given that the bulk of the money chasing stocks is controlled by people who understand valuation, risk-reward, CAPM and Sharpe Ratios?

Before one can even attempt an answer to this question, it's pragmatic to accept that stocks prices do often swing way beyond the point of rationality even if we don't know the reasons why.

For the past year or more, depending on your valuation model, stocks have been either very fully-priced or over-priced. The pendulum swung in the opposite direction for a brief six weeks in May-June 2006, when a sell off knocked 31 per cent off peak values. But then prices climbed right back and surged to new heights.

The downturn that started in mid-February 2007 has led to 16 per cent correction (peak 4245 to recent low of 3554) so far. At current levels of PE 17-18, the Nifty is still over-valued. Valuations in the range of PE 12-13 would be more comfortable given the interest rate situation.

On historical performance, an "over-correction" to PE 10-11 would be quite likely at the absolute bottom. The consensus 2007-8 EPS growth estimates are in the range of 15-20 per cent for the Nifty-50. That translates to a bottom at about 2950-3000 if there is a correction in the next fiscal.

Earnings growth should pick up quite a bit by 2008-9 because capacity expansions across various industries would start to come on-stream in that fiscal. It's a moot point however, if the Nifty will respond strongly in 2008-9 even to spectacular earnings growth.

That is election year both in India and in the US. Uncertainty about policymaking will tend to rein the bulls in through 2008-9. By 2009-10, the political situation should have settled. Barring the appointment of Gurudas Dasgupta or one of his fellow-travellers as the Finance Minister, investors will again be focused on the fundamentals.

Therefore, it may be reasonable to expect that the Nifty will trade close to its current price levels, or even below, through much of the next two years. After that, it should pick up sharply since prices follow profits in the long run. And the earnings trend of the Indian economy is more than strong enough to survive political uncertainty.

So the next two years represent a strong buying opportunity for anybody with a 3-4 year perspective. Systematic investments across a reasonably-diversified portfolio should yield excellent returns. A lot of money will enter the market on that logic.

That is where the fun starts. If there is enough long-term buying, it may spark a series of rallies. Each rally will bring in traders and speculators with opposed perspectives. Some traders will be bullish enough to go long with leveraged funds. Others will be overtly bearish and try to sell into every rally. The interplay of bulls and bears will create the perfect recipe for lots of price volatility without major trading gains.

If you've got the trading skills and the force is with you, you could make a lot of money on the right side of those swings. Otherwise, you should probably buy every time the market is below 3750. Over 3-4 years, even a portfolio of index funds held at 3600-3700 averages will beat most other financial assets.