The stock market has fallen sharply from its record high scaled in end-January, taking the market valuation to reasonable levels. At 17.7 times estimated FY19 earnings, the Nifty is now trading closer to its long-term historical averages and experts believe it is not expensive on the back of earnings bottoming out.

Many analysts believe the recent decline in stocks offers a good buying opportunity, but only in companies that have “quality with earnings visibility.” Investors have to be really choosy in the current market.

“Given our expectations of elevated volatility and earnings recovery, we believe proper stock-picking will be more rewarding in CY18, unlike the previous year, which was characterised by a broad-based market rally. Cooling off of bond yields post the announcement of the H1 government borrowing calendar is incrementally positive from valuations viewpoint,” says Motilal Securities in a recent report. “We continue to prefer large-caps over mid-caps, given the sharp valuation premium of mid-caps. Moreover, our CY18 theme of ‘Consumption Recovery’ is playing out well, with strong performances across consumer and auto companies,” the report noted.

However, the market is seeing huge volatility as investors are concerned about the state elections this year and the general elections in 2019.

Large investors are also concerned about India's growth story due to peaking crude prices and the slow pace in earnings recovery. This could be the reason foreign portfolio investors have reduced their India position.

The market has seen the deepest and longest earnings recession in history, having lasted in excess of seven years and led to a 20 per cent drawdown from the top.

According to Morgan Stanley, for a bullish investor, high beta stocks with low relative volatility could be the best stock picking approach given that such stocks come with a higher return correlation and, hence, do well in a rising market.

For defensive investors, Morgan Stanley said, telecoms offers the best of mix of low beta (currently below median, too) and high relative volatility (around median). Technology is the next best defensive sector on the basis of its beta configuration. For investors wishing to be bullish, the highest return correlations come in financials, consumer discretionary and materials.

But the market faces risks from the rising bond yields. Bond yields, in India and across the world, have been rising sharply in the last few months. In fact, when the monetary policy was announced by the RBI on April 3, the bond yields had touched a low of 7.12 per cent and have since then rallied by more than 60 basis points to the 7.73 per cent levels.

Bond yields started moving up in July last year but fell a bit after the monetary policy painted a rather dovish picture. However, the Monetary Policy Committee minutes were quite emphatic about the risk of inflation. Inflation in 2018 is likely to be higher for two reasons. Firstly, the food prices of Kharif crops are likely to be higher after the Budget 2018 had promised a 150 per cent assured MSP on the cost of production. Secondly, oil prices are consistently trending higher and at $74/ a barrel, the risk of a higher imported inflation is quite high. When inflation is high, bond yields are likely to trend higher. The US Fed has adopted a hawkish tone and it means that the RBI could also be compelled to raise repo rates. Above all, the higher fiscal deficit outlook for the year also raises questions over bond yields.

Indian bond yields on 10-year benchmark are nearly 400-500 basis points higher than the US yields. The higher the yield spread, the more attractive Indian debt becomes for foreign bond investors. When FPIs pull out money from debt, it negatively impacts the rupee--as happened in 2013 in a big way and to lesser extents in 2016 and 2018. A weak rupee will reduce equity returns in dollar terms, something which FPIs are not comfortable with. They may not really see any point in holding on to Indian assets when the rupee is weakening and that could lead to a sell-off in equities, too. This is something the equity market is cautious about.

Despite the market correction, mid-caps currently trade at higher valuation, so, large-caps have become favourites of FII investors and Indian fund managers. FIIs, anyway, are more focused on large-caps than mid-caps.

Vinod Nair, head research at Geojit Financial Services, says some important risk indicators are creeping up, like crude at a four-year high, increase in government 10-year bond yield and depreciation in the rupee to a near 12-month high. The results season will gather pace in the coming weeks, with major heavy weights yet to unveil their results. “As per the recent history, results during the second phase are dull. Out flow of foreign funds due to rich valuation is a concern to the market.” Nair said the market may start to factor the likely result of the Karnataka state election based on pre-poll surveys. Any setback to the central ruling party may cast a cloud on the general elections in 2019.

It is expected that the government will look to drive consumption demand in an election year. However, a further spike in crude oil prices remains a key risk as it can distort the improving macro narrative.

Analysts say the market is still in a corrective mode. Results will not make any material impact on the stocks and the market, but the outcome of the Karnataka elections will be a crucial event for the market to decide its next move. A view is that the market can still be predicted, but none can foresee the election results.

On the sectoral front, realty, pharma, power, oil & gas, metals and cement are expected to continue their corrective journey. Profit-booking could emerge at higher levels in information technology and fast moving consumer goods sectors.

On the whole, May would be a lacklustre month for the market, except for the big event of election results.

ashwinpunnen@mydigitalfc.com