"Thus, the May effect may not play out as per the last four years based on cheap valuations and the generally bullish mood prevailing in the market. One should ideally have a net long exposure till the election outcome and reassess one's position there onward."
One of the most popularly cited examples of market anomalies which contradict an efficient market hypothesis - is the sell in May effect. Historically, May has always been a period of negative returns for equities. Finance academics cite many reasons for this but they are beyond the scope of this article.
In particular, the sell in May theory has held true over the short run for Asian equities ex-Japan. Credit Suisse points out that equities saw a correction between 5-10 percent in each of the past four years during April 30 to June 30. This time however, in all probability, we might not witness a correction in equities.
Although we have seen a broad market rally in Asian equities ex-Japan, valuations still remain very cheap at current levels. Credit Suisse points out that MSCI Asia ex-Japan's current price-to-book is 1.55, the lowest level in the last five years. Further, the price-to-book gap between MSCI Asia ex-Japan and the World is at -0.48x, the biggest in the last five years.
Net foreign buying on a rolling 12-months basis is the second lowest of the last five years. Thus, if macro fundamentals improve further, there is scope for further foreign funds buying which would be bullish for equities.
If Asian markets hold up well and we do not hear extremely dovish comments out of the US Federal Open Market Committee - minutes later this week, the pre-election rally in India is all set to continue.
It may be prudent to place bullish bets on cyclical stocks which include some beaten down infrastructure and real estate names. They have hugely underperformed the market since the crisis of 2008 and have recently witnessed some buying interest.
While cyclicals have historically underperformed during the May-June correction, it should be noted that the price-to-book gap between cyclicals and defensives is the second biggest of the last five years for Asia ex Japan equities according to Credit Suisse.
Thus, they are a good value buy at this juncture provided the new central government can put in place the right policy reforms which would kick start the investment cycle. From a trader's perspective, buying these high beta names would yield excess returns over the index if the upside momentum is indeed maintained.
The next few weeks may also provide some sideways movements on the Nifty and we can expect volatility to increase as we get closer to the all important result day May 16. The Indian VIX, for May 13 expiry closed at 34.31 on the last trading session. There are two ways one can look at this from here.
If one is aggressively long the market, one can look to hedge his exposure by going long the VIX futures contract. This is based on the historical negative correlation between the Nifty and the VIX. However, the VIX appears to be overbought at current levels and if one is expecting a favourable market outcome on May 16 -, the VIX is likely to witness a sharp sell-off. It is important to note that the VIX has climbed from levels under 20 in just over a few months.
Thus, the May effect may not play out as per the last four years based on cheap valuations and the generally bullish mood prevailing in the market. One should ideally have a net long exposure till the election outcome and reassess one's position there onward.
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