NIFTY : The Election Upside (And Downside In Case You Forgot The Possibility)

Since middle of Feb, NSE Nifty has totally broke off from the general emerging market performance. Before that, both were in lock-step as far as you look back. Presumably this is all about the 16th general election 2014 and an expected Modified result. We already have a strong anticipatory rally, and May 2014 options implied vols have shot up to historical highs. So I take a quick back-of-the-envelope look at different scenarios to gauge upside and downside potential once the results are over

I run 6 different scenarios - the first once simply assumes we repeat the 2009 performance. Before the lections, Nifty rallied 43% in recovery since the bottom on March. After the election, Nifty rallied 20% after the results were out and sustained to another 7% rally till the peak on June. So total 27% approximately. The next scenario considers the possibility that a part of this rally is already anticipated by the markets. In 2009 it was a kind of surprise. The 3rd and 4th scenarios involve a rough event study on past elections, taking in to account the change during the election period and also past 12 month performance. I see a strong relationship there (see below figures) and forecast the expected returns based on these models

the 5th and 6th takes a different approach and looks at the relative valuation. It compares relative P/E to MSCI EM index and S&P500 Index. And both indicates a significant downward correction

So it is no surprise the May options implied volatilities are at historical highs. And given everyone expecting a rally, the skew is trading relativly cheap, not far from historical lows.

It is wise to remember 2009 was perhaps a comeback rally following the blood-bath during and after the Lehman crisis. And every single market was rallying, including emerging ones. This time, even the optimists on steriods will not conclude that way. Tt is not very clear if the BJP led NDA will have enough seats to avoid a troublesome coalition. And if the Congress led UPA is able to form a government the market will react negatively with a good chance. It is wise to keep a perspective. But I would say any sharp correction after the rally will be a significant buying opportunities for the value investors. In the end, irrespective of who comes to power, India will need significant reforms to keep alive the BRIC story. And I am hopefull if the people demand it, it will be delivered

By the way, here is an interesting look at the vulnerability of other emerging markets from a serious Chinese slowdown.