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Rising Tide Lifts All Boats / Stocks – Go Selective

May 19, 2009

We had anticipated a strong market rally, in our view the 20-25% higher closing prices of several index heavyweights reflects the strong pull from the futures market rather than genuine price discovery in the cash market. The substantially higher activity in futures and options (US$560m) supports anecdotal evidence that futures were the preferred choice of participants for gaining exposure to the expected market rally on the basis of cost and effectiveness.

The extent of the rally in some names is not that surprising if viewed against the re-rating that would be predicted by a Gordon Growth Model for an event that resulted in a significant reduction in the equity-risk premium. For the Sensex, the model suggests 25% upside to PB multiples for a 50bps reduction in market risk premium, based on assumptions of 16% sustainable ROE and 10% long-term growth (a lower growth assumption would render the model invalid during the 1998-99 period). A 50bps reduction in the equity risk premium would not be unrealistic for an event that represents a shift from an unstable ruling coalition to stable coalition with strong leadership, given that average equity risk premium during 1998-2009, as derived from our model, has been 5.6%.

In some cases, stocks have participated fully in the rally despite question marks on fundamentals. Financials look well positioned for further re-rating while Capital Goods like BHEL look fully priced in. However, stay invested in Financials for more action.

Be selective while BUYING any Midcap or Smallcap as the word from our Guruji was Caution with an underlying tone of optimism.

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