The narrative around whether Mr Modi is coming back or not next year is going to be a driving force for market sentiment and multiples for the next 12 months, says Gautam Chhaochharia, ED & Head of India Research, UBS, talking to ET Now.Edited excerpts:Why is there such a selloff in mid-cap stocks? The fact that the tide has turned for small and mid-cap stocks is quite worrying?For a few reasons possibly; one is the starting valuations were becoming almost frothy and not just rich for a few mid-caps and small caps. Secondly, macro headwinds are hurting local sentiments. People had made a lot of money in small mid-caps. The normal tendency would be to book profits there rather than keep hoping for more upside for valuations. The last thing is that the flows from foreign investors have been weak this year, both in absolute terms as well as in the context of global emerging market flows. That also adds to the negative sentiment for this asset class for local investors including HNIs and mutual funds.Where are we headed from here? Do you feel that some of these mid-caps, which are falling for no reason and are fundamentally sound companies, are almost reaching that trough point where they could again be considered for a buy? Is there still some more pain to go for mid and small caps at large? It is always tricky to have a single view on Mid and small caps as an asset class. There are always bottom-up opportunities in the correction phase. There are mid and small caps which have done well in absolute terms also. But , if we want to stretch that argument, valuations in mid and small cap indices — both in absolute as well as in relation to large caps — is still not a level where we would say go overweight on mid-caps. We are still underweight in mid-caps from the broader market perspective. But yes, select opportunities always are there.How are you approaching the markets post this earnings season especially, as there has been a big carnage in the broader markets?It will be a mix of many signals. The global signals will still be the dominant driver possibly. The local signals are the earnings. The earnings season has been reasonably okay this time with many consumer facing businesses reporting positive surprise in volume growth.On the other hand, in the next few months we will see if there is any potential support to rural economy from the government in the form of stimulus or fiscal expansion. The various models which we have elaborated and analysed in our recent note, including the model followed by MP or Telangana, would have a bearing on how the specific mid-cap and small cap stocks as well as the broader markets perform. Lastly, there is the narrative around 2019 elections. We are just a year away from the national elections. The narrative around whether Mr Modi is coming back or not next year will be a driving force for market sentiment and multiples for the next 12 months.Do you think the Karnataka election was well priced in with that 1.5% volatility that we saw on the index and also the fact that mid-caps after having started off the day very well, fell pretty sharply from the top of the day?The markets are pricing in that the BJP will form a government in Karnataka but beyond Karnataka. it is not about whether they form a government in Karnataka or not. The bigger narrative here is what it means for 2019 elections and that is what will drive the market reactions. So, if the Karnataka outcome starts showing up that the JD(S) and Congress are getting together, then it does add some level of discomfort around the Modi narrative for 2019. What is more important for investors to track is the fragmentation or unity among opposition parties and that will be the bigger delta in terms of the possibility of this government coming back in 2019. Markets clearly hope for and are pricing in Mr Modi’s return given the strong track-record of reforms over the last four years.Are we done with the highs for the year and it is going to be perhaps very difficult for markets to a) go to the previous high and then b)stay above that?Going above the highs is not too much from the current levels. It can definitely go there. You need four, five days of strong flows or strong buying and so that is not a big deal. But yes, fundamentally our base case for Nifty for December 2018 still remains 10500 and if I look at our upside downside scenarios also, the risk reward is definitely not attractive. Our recommendation to investors is not to get in or buy at these levels. They will get better opportunities later in the year.When we started the year, nobody was pencilling in an uptick of 20% in crude prices. Nobody was pencilling in a 70, 80 or even a 100 bps uptick in bond yields, or a LTCG. Yet markets have been strong. The expensive stocks have even become bigger and the PE multiples for HUL, Asian Paints, even Maruti has only expanded. Why are markets getting more and more polarised?As you said, it is a mix of rising macro concerns but still strong inflows. If you have inflows, you have to buy stocks. If you have concerns, then you try to hide in quality. Exactly that is what is playing out and as for the markets as long as the flows remain strong the markets may not correct in a big way.Even with India’s rising macro concerns, over the last few months, the global macro backdrop has been quite supportive so that we have seen risk assets largely being okay. Emerging markets have seen more than $50 billion of inflows and that is why we have not seen any major outflows out of Indian equity markets despite some concerns on valuations and macro. The key here is the sentiment and flows. Sentiment has taken a back seat over the last two-three months given the macro concerns but the flows remains strong and we still have not seen any desperation amongst investors globally or locally to really start cutting down exposures in India. What should be the approach for the rest of the year? At a time of dwindling macros, there is still a little bit of a question mark on which way globally things are headed. Crude is a big cause of concern which is also weighing heavy on our macros and then there is the political uncertainty. Should one buy more of the same – more of HDFC Banks, Marutis, TCSs of the world or take a more bottom up approach?I would say a mix of both. In this backdrop, the quality names will do well but there are select bottom up opportunities sectorally and stock wise, which investors should push because the long-term story for India still remains intact. There is debate on global growth outlook, about a synchronised recovery or lack of that. But nobody is saying we will see a big recession anytime in a hurry. The backdrop is still okay and we should not panic where you sell out and get out in a hurry. Look at the right stocks at the right levels. Bottom up always works in India and this year also should continue to work in India.How would you approach the entire consumption theme and select stocks within that?We are looking at two themes there. One is in general, the rural exposed businesses should do well whether we see a major policy support for rural or more rhetoric than actual money being spent. Any which way, the rural sectors will be supported this year ahead of elections and the commentary there should be positive.Secondly, companies or specific companies on a bottom-up basis where we are seeing clear signs or normalisation of supply chain, gaining market share from informal sector as GST, e-way bill etc gets rolled out this year. Those would be the other opportunities from a bottom up fundamental perspective. And then we overlay that with where the stocks multiples are compared to recent history, medium term history and how the stocks have done and see what they are pricing in and that does throw up interesting bottom up ideas from that space and that is what we will stick to.Where is value emerging in the mid-cap space now.So, there is no space as such but yes bottom up there are opportunities in segments where the micro picking up is not broad-based but there are signals for sectors or stocks already visible. That would be an interesting area to look at. That is where the value is because the markets are not pricing in that recovery. Markets are reacting a lot more in terms of immediate numbers, not so much forward looking. That’s why it is reacting very violently in terms of the Q4 numbers on both positive and negative side.