The Hindu Business Line : Bracing for Budget effect

We may be poised for a period of lacklustre price trends. To handle such a trend, it may be better to hedge risks by buying Nifty puts or short futures than bowing out of the equity space.

`When in doubt, exit' may be the time-tested philosophy of traders. No wonder, several brokers are advising clients to convert at least half of their equity holdings to cash. The case for an exit, though, may not have been made for retail traders, as they see institutional investors threatening to flood the market with liquidity. Adding to such conflicting opinions is the market trend between February and October each year. The Sensex has usually languished over this period.

For long-term investors, though, such passionate opinion about valuations and likely trends may be less relevant. If they have worked out an asset allocation pattern that ties in with their needs and risk preferences, there is little that they need to do, except stick to the allocation pattern. That should, by and large, take care of the contingencies. The present time is not so unusual and reeking of such speculative excesses that they should think about running away from equities.

Budget effect

Between February and October every year, stock prices stagnate. Since 1991, ten of the 14 summers have been poor investment season. In six of those summers, the Sensex shed between 6 per cent and 30 per cent. In four years, it barely moved. In addition, since February 2002, there have been seven consecutive half-years of growth in stock prices. This is the longest winning streak for stocks since 1991. In addition, for only the third time since 1991, the Sensex has gained more than 30 per cent just before the Budget. All this indicates that the time may now be ripe for a correction, or at least a protracted period of flat trend. That may be necessary to allow the stock market to weed out undesirable elements and identify the promising candidates.

If this does happen, then the impact could be more severe on a section of the mid- and small-cap stocks. A lot of money has already flowed into large-cap stocks, perhaps in anticipation of precisely such a denouement. This is reflected in the gains in various indices since October 2005. The Sensex has appreciated by 33 while the Nifty Junior has gained only 25 per cent, as investors feel safer to bid more for large-cap stocks. The BSE 500, too, has trailed the Sensex, suggesting that mid- and small-caps had less to celebrate than large-caps.

The unknown quantity of course is the Budget. If it does not stoke inflationary pressures and strengthens the ground for stable interest rates, then the market would breathe a sigh of relief. The number that investors would be keenly looking out for is the proposed market borrowings. If the Finance Minister plans to borrow much more, it could spoil sentiment.

Case for stocks

At the outset, the case for stocks is still strong. Valuation of the top 500 stocks suggests that investors can expect after-tax annual returns of 7-10 per cent from stocks over the next five years. That is still substantially higher than what you can expect from bonds. That income from stocks is not taxed while income from debt is, at 30 per cent , contributes to the attractiveness of stocks.

Maybe real-estate is now a superior option than stocks. But official statistics indicate that Indian households are heavily invested in physical assets such as land and gold. They still put much less money annually in stocks and equity mutual funds than is desirable. The case for stocks is, therefore, strong though stock, or fund manager, selection still holds the key. The expected returns though could be in single-digit.

So how should a long-term investor play the risk of a downturn? Rather than selling and exiting, a better option would be to buy some short futures contracts or Nifty puts. Writing call options on stocks that an investor holds could be another option. Hedging risks could be more prudent than exiting the markets completely.

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