The railways, the weather and cricket are three subjects on which every Indian is supposed to have an informed opinion. Cricket doesn't seem to be in great shape, what with fixing allegations, a lack of bowling and Pujara's bum knee. The railways is suffering from a huge cash crunch.
As to the weather, El Nino, aka the little boy, is working his mischief again. There's a fairly credible set of predictions, which suggest the monsoon will be below normal. That could mean upwards pressure on food prices, which will derail the Reserve Bank of India (RBI)'s hopes of inflation gliding down.
Fears of a rate hike in the next RBI policy review in June did have a negative effect on expectations. However, in rational terms, RBI is most likely to stand pat and postpone decisions in its June review. Raghuram Rajan will want to see the new Budget and assess the ability of the 16th Lok Sabha to get things done before taking any sort of call on interest rates. (MAGIC NUMBER GAME)
There are several other fears on the external front. The situation in Ukraine remains unpleasant and it has, if anything, escalated in the past fortnight. It's impossible to figure out where this could go, but at some stage, the markets will get jittery if this continues. Energy prices in particular, could spike.
China has seen its currency slide to the lower end of the "permitted trading range" for the yuan. Traders need to guess if this is because the Chinese central bank is looking to devalue for the usual reasons. Or, is it because weak Chinese gross domestic product growth and dodgy loan portfolios are coming under focus? If there is a currency defence, when and where will the yuan be defended? A defence would probably mean that other currencies could weaken.
The dollar has some sort of counter-balancing mechanism in force in that the Fed is still cutting back the volume of balance-sheet expansion. In the last four months, the Fed has cut back from $85 billion per month to $45 billion per month. If the same pace of $10 billion per month cutbacks is maintained, the Quantitative Easing 3 will end by August-September. As the tapering continues, the dollar is likely to harden. But the euro and the yen could dive if the Chinese decide to suddenly defend their currency.
Meantime, the rupee remains ranged between 60-61 to the dollar and is now towards the higher end of the trading range. The foreign institutional investors (FIIs) have remained steady buyers through April, though their volume of purchases reduced considerably. Interestingly, the domestic institutional investors (DIIs) sold more than the FIIs bought. By implication, domestic retail was net positive.
The revelation that India became the world's third-largest economy in 2011, in purchasing power parity terms, has been a useful talking point for the politicians. The market has quite rightly, ignored it. But, of course, the market will not ignore politics at this instant. Barring catastrophic disasters, or a full-blown war in Ukraine, the formation of the 16th Lok Sabha will occupy the largest share of trader mindspace.
Some number-crunching of Nifty returns by Capitalmind.in suggests that May is often the most volatile month in the year. Between 1994-2014, May had an average return of 0.5 per cent with a standard deviation of 10.2 per cent. The maximum positive return was 28 per cent in 2009, when the United Progressive Alliance retained power in the elections and continuity was assured. The largest loss of 17 per cent came in 2004, when the National Democratic Alliance (NDA) lost an election it was confidently expected to win.
The Bharatiya Janata Party (BJP) is, of course, expected to win the 2014 elections and if it does so, the market could zoom. This is especially true because the last two weeks have seen some profit-booking. Only players with deep pockets are left in the game now. Importantly, the DIIs could bring in fresh funds.
If the BJP cannot put a government together, the market will undoubtedly fall. By how much is a difficult question. In 2004, the huge crash was due to the BJP coming in second to the Congress, thereby eliminating chances of the NDA forming a government. This is an unlikely if not impossible situation in 2014. Assuming the BJP is the largest party by a fair margin, there would be a period of uncertainty while traders wait for the magic number, 272. We may see very high volatility without too strong a sense of direction if the BJP is forced into a period of extended horse-trading.
This is the perfect situation for deploying options. The volatility is likely to rise after May 16 and continue to remain high until May 29 (the settlement). A trader could either go with a directional bet of bullish or bearish by buying the appropriate Nifty calls or puts respectively. Or the trader could deploy strangles by buying both calls and puts - in this case, any big swing would be profitable. Even a pure investor might consider using options, buying puts as a once-in-five-years hedging tool.
The problem with an event of the dimensions of the general elections is that it cannot be ignored. This month and maybe June could see moves that are large enough to affect even the returns of very long-term players.
In terms of valuations, the equation remains unattractive for any value investor. The PE for the Nifty is about 19 while the Earnings growth rate is 10-11 per cent. In technical terms, there are huge amounts of open interest in the Nifty 7,500 call and the 6,000 put. This means people are betting serious money on moves of over 10 per cent away from the current index levels.
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
