The storm clouds of inflation, higher interest rates and global jitters had been hovering over the stock market much before the Budget, which, given that it was long on populism and short on reforms, took a further toll on equity values.
The Sensex cracked 540 points on Wednesday, making it a 1,200-point fall in a fortnight. As the dust settles after the Budget, there is a key question: Is the market poised for a spirited pull-back and how can investors play the volatile equity theme over the next few months?
Investors need to take stock of three key variables:
Global nervousness and portfolio flows: The fear of a crackdown on speculation in China (which was the best performing market in 2006) has triggered massive concerns across the globe.
The prospect of tighter monetary conditions across Asia (including Japan) may stem the flow of easy money away from the fancied emerging markets.
There is a possibility that funds may flow away from the BRIC countries towards Malaysia, Indonesia or the Philippines in the short run. This trend may be aggravated if the threat of a slowdown in US growth intensifies.
The latest figures suggest that the US economy grew by an annual pace of 2.2 per cent compared to 3.5 per cent earlier.
Since FII flows are directly linked to these factors, any sluggishness in liquidity will have a direct impact on market movements in India.
Overhang of interest rates: The domestic interest rate cycle has been on an upturn for the past few months (see related story). Despite recent policy moves on this front by the Reserve Bank of India, some economic commentators and analysts feel that the central bank may be behind the curve in increasing interest rates.
Taming inflation may not be easy for the government, if one goes by the hike in cement and steel prices, post-Budget.
If inflation hardens over the next quarter, the Government may be left with no choice but to increase interest rates further.
From an investment valuation standpoint, rising interest rates are usually a negative for the stock market as they are negative for corporate earnings and increase the risk-free rate used to calculate cost of capital. And the impact of this will catch up with the markets.
No sectoral favourites: For the first time over the past year, investors may be running out of sector favourites. Heavyweight sectors such as oil and gas, automobiles and pharma have been out of favour the past quarter.
And post-Budget, it appears that investors need to be selective in stock-picking, even in such fancied sectors as construction, capital goods, software and cement.
Among the index heavyweights, barring a couple of telecom stocks, the market is running out of investment ideas.
Despite attractive valuations, in the absence of investment triggers, the mid-cap and small-cap stocks continue to languish.
In the backdrop of these factors, investors may be better off:
Staying on the sidelines in the near term, without taking fresh exposures. Inflationary pressures may worsen in the near term, as the supply side may not be able catch up with demand quickly.
If it persists, manufacturing companies may face margin pressures. On the contrary, from these levels, even if the market were to rally, it may offer only a 10 per cent return, which may not adequately compensate the risks involved.
Consider booking partial profits in some of their deep in-the-money positions.
As a measure to reduce risk through diversification, you could move some of those profits into mutual funds with multi-cap portfolios that straddle large-, mid- and small-cap stocks.
Funds such as HDFC Equity and Franklin Prima Plus may be ideal investments, apart from a dose of short-term debt.
As the long-term India story remains intact, investors with a long-term perspective can stay invested for now.
However, more attractive opportunities may open up later for taking fresh exposures at lower levels.