Where is the Indian stock market headed?

The change in market sentiment can be attributed to a reaffirmation of the NDA government coming to power by recent opinion polls. The stock market was worried about the emergence of the Aam Admi Party (AAP) and its impact on the General election outcome. The market feared the possibility of a hung assembly or a third-front government, pushing the reform agenda in cold storage. But follow-up opinion polls reiterated that NDA-led government was coming to power and the AAP’s fortunes would be limited to 8-15 seats, at best. Coupled with a stable currency, reduction in trade deficit, containment of fiscal deficit and fall in inflation, FII fund flow remained strong and propped up the market.

The party to continue… Time to load up

Although Opinion polls have got it wrong at times in the past, one must note that they tend to gauge the mood more accurately closer to the election; and they are of the view that the NDA formation is gaining momentum. Our own projection supports – we expect 185-195 seats for the BJP and enough post-poll support to form a government. We believe the market sentiment will remain upbeat and the rally will not pause, albeit minor corrections. We also see the possibility of the market rising ~5% on a single trading day post confirmation of the expected General election outcome.

The improved sentiment, however, is only moderately captured in stock prices in our view and leaves scope for more upside to the market. Over the last three months, the Sensex has risen 3.2% but S&P500 and Europe’s STOXX600 has also moved 3% and 2.4% respectively. So, it’s not a massive outperformance by the Indian market. Valuations are still reasonable at 14x FY15 and 12x FY16 earnings for the Nifty. Although these valuations are at a premium to other emerging markets, India’s ROE is also higher. Furthermore, valuations are at a discount to what India has historically enjoyed.

Corporate profitability, which remained highly depressed (our calculation finds them 30-35% below normative level) for the last six years, is showing signs of improvement. Earnings growth revisions are encouraging; a gradual uptick in demand, depreciated currency, cost control by companies over last few years and efforts to reduce debt levels will lead to a 14-16% growth in Nifty and Sensex EPS earnings in FY15 and FY16, following a mere 8% growth in FY14E.

A bottoming out of India’s GDP growth, inflation reasonably under control and near term stability in the Rupee will support further market upside. FIIs are likely to remain overweight on India given all the above factors and given that there’s not much to choose from other emerging market economies.

We believe it’s time to load up stocks in the portfolio, especially quality midcap names. History also supports this viewpoint; the equity market has seen healthy up move for a couple of years following the General election. Our target for the Nifty is 7200 with a low probability of a major correction. We do not see a market fall to below 6200 till the new government is formed in June. The biggest near-term risk to our call is the election outcome itself since a hung assembly will spoil the party.

H2 2014 may see consolidation; next 5 years belong to the Bulls

We anticipate the major market run-up to take place in the first half of 2014, even before the start of delivery by the new government. The post election phase (H2 2014) will be one of consolidation, driven by slow economic recovery and global factors.

The biggest risk from a medium term view is the rise in global interest rates. Coupled with the ongoing Fed taper, there could be a flight of capital from emerging markets and a resultant return of weakness in the INR in H2 2014. Emerging markets like India run the risk of high FII ownership, which is currently at all-time high. Currency depreciation would mean sticky inflation; El Nino fear already threatens to affect monsoons this year. High interest rate cycle may be prolonged if inflation is sticky and global rates are rising, at a time when the saving-investment gap is still high. While there is a lot of euphoria surrounding the new government, the economic recovery will not be a V-shaped one.

Having said that, the next 5-6 years will be a time for equities. The stock market has seen a price and time correction in the last six years. A change of guard at the Centre, favourable demographics, conservative banking system (notwithstanding near term asset quality concerns) and supportive valuations augur well for a long market run. We believe the time to raise equity exposure has come. The next few months present a tactical opportunity to buy Indian equities.