A recent presentation by Prashant Jain of HDFC [Get Quote] Asset Management Company made some interesting points. Since Feb 2006, the Sensex, a weighted average index, has climbed from 10,000 (Feb 2006) to 20,000 (December 2007) and then reacted back to 17,500 (Feb 2008).

However, some Sensex constituents (Reliance, Larsen aad Toubro) have risen 300 per cent and others (Tata Motors [Get Quote], Dr Reddys) have barely moved. A few (Wipro [Get Quote], Hero Honda) have even given negative returns during this phase.

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Therefore, some companies are trading at 30,000-40,000 Sensex level, while others are languishing at 10,000 levels. Similarly, the index as a whole is trading at about 20 price earning while various companies are trading well above or well below that average discount. Therefore, despite the broad bull market, some leading stocks have been in a bear market.

Part of the higher Sensex valuations can be attributed to value the market attaches to businesses that are not yet generating profits (for example, RPL or the insurance businesses of financial players such as HDFC and Stae Bank of India [Get Quote]).

If we assume that those valuations are more or less justified, we could argue the market PE is misleadingly high. Given that those businesses will eventually (perhaps quickly) start generating earnings, the forward PE multiples will fall significantly.

Jain estimates that in terms of 2009-10, the Sensex is trading at 15-16 PE, if we adjust for the embedded value factor.

So is India expensive or cheap? Jain thinks that, given growth prospects, it is reasonably-priced. His sector preferences are capital goods among highly valued sectors and banks among moderately-valued.

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About the low-valued sectors such as IT, FMCG, pharmaceuticals, automobiles, non-ferrous metals and cement, his view is that some have been unfairly punished.

Most interestingly, he says that there is a strong case for FIIs to treat India like a core asset (where capital is permanently invested) rather than an emerging market where capital moves in and out on a cyclical basis.

According to Jain, India is much lower-risk than other emerging markets as well as being very high growth. The only market in the same league in terms of growth is the PRC and this is even more highly-valued.

There are several interesting implications if you concur with Jain's logic and try to extend it. One is that FIIs will always leave a core amount invested in Indian equity if they concur with Jain and treat India like a core asset.

In that case, the Rs 17,000-plus crore that exited in January 2008, was a "rebalancing" rather than the beginning of a stampede. If true, this is good news for all those who are terrified of bear markets.

A second conclusion is that the highest returns will come from stocks that are currently beaten down during the next cyclical upturn in the Indian economy.

A third possibility is that the safest returns, as opposed to the highest, will come from capital goods and the financial sector. A fourth conclusion is that highly-valued sectors such as private sector refiners (Essar, RIL [Get Quote], RPL) and telecom (RComm, Airtel) could see more selling before their valuations align with their fundamental prospects.

The second, third and fourth points are actionable by Indian investors and traders in very different ways.

If you wish to act on the possibility that beaten-down cyclicals are likely to yield high long-term returns, accumulate the worst performers in the Sensex/ Nifty basket with a 2-3 year perspective. Since there is every chance the cycle will get worse before it gets better, you will have to invest systematically for low average prices.

On the other hand, if you want safer returns, look at capital goods and banks. The returns here have been decent but there is still a moderate upside and the recent sell-off has reduced the risks.

An aggressive investor with this mindset will pick the stocks that have lost most ground in the past two months. A conservative investor will pick the ones that have displayed the most defensive strength.

If you want to live on the wild side, start looking for short positions in refiners and telecom. This last is difficult to action because stock-lending mechanisms are not easily available.

The best you can do is hold short futures positions. Given the risks, this can't be done on a fire-and-forget basis. But it might make sense to keep some margin ready and target these sectors the next time the market slides.