This isn’t the first time the markets have run up in the hope of a Narendra Modi victory in the Lok Sabha elections. There was a little rally after his announcement as the Bharatiya Janata Party’s candidate and another one in December after the state election results. That jubilation, though, was tempered by worries about debutant Aam Aadmi Party’s superlative performance in the Delhi elections. But since Kejriwal’s resignation as chief minister, hope has flowered anew in the markets and they have been doing rather well.

That story might be a little too glib. After all, since last September, we’ve also seen a big cut in the current account deficit and the rupee has remained stable. There has also been some fiscal correction, although admittedly of dodgy quality. Inflation has come off its high. These factors may have contributed to the rally.

Does a general election have an effect on stocks? The problem is that markets also move up and down on global cues, so it’s necessary to sift out the global factors affecting market performance. One way of doing that is to compare the MSCI India index with the MSCI Emerging Markets (EM) index.

In the run-up to the 2004 elections, MSCI India fell around 5% in the two months to the date for counting of votes, beating MSCI EM, which fell 10.6% over the same period. And in 2009, MSCI India was up 39% in the two months till the counting day, compared with a 34% rise for MSCI EM. Irrespective of the very different conditions prevailing in 2004 and 2009, the point is that in both these election years, the Indian markets outperformed emerging markets in the two months prior to the date of counting of votes.

Now consider what happened in the month following the counting of votes. In 2004, the MSCI India index had fallen 9%, while MSCI EM had gone up 0.5%. In 2009, however, MSCI India rose 27%, while MSCI EM went up 11%. There could have been many other factors for this divergence, but the big difference between 2004 and 2009 was that in 2004 the United Progressive Alliance (UPA) had to take the support of the Left parties, a terribly unwelcome development from the point of view of the markets, apart from the shock of seeing market favourite National Democratic Alliance (NDA) lose. In 2009, though, UPA was able to jettison the Left and the markets were under the illusion that it cleared the way for reforms.

Reading the tea leaves from these two elections, we can then say it’s likely the Indian market will outperform other emerging markets in the run-up to the election results. The more seats for NDA predicted by the opinion polls, the higher the margin of outperformance.

After the results are declared, if they are to the markets’ liking, which speaking plainly means an NDA government is in power, the outperformance should continue for some time. If, however, the results lead to an unstable coalition government, Indian markets are likely to underperform.

True, the headwinds to the economy remain. Investment growth still hasn’t picked up. The fall in inflation could be seasonal. Interest rates are unlikely to come down in a hurry. The latest data show a deceleration in the growth of non-food credit. Stressed assets in the banking sector are a big risk. And the problems created by the land acquisition law will continue. In short, there’s no silver bullet and removing the supply-side constraints will take time.

But markets run up on hope. Also, recall that in 2013, when the taper news hit the markets, foreign institutional investors discriminated among emerging markets, punishing those with unsustainable current account deficits the most. India was one of the markets that bore the brunt of the pullout. Now that India has taken steps to bring down its twin deficits and taken steps to combat inflation, shouldn’t the Indian market do better than its peers?

Then there’s the question of valuations. Yes, the Indian market’s premium relative to other emerging markets is high. But the question is: the valuation of which segment of the market? Many cyclical stocks are pretty cheap and these are the stocks that will benefit from a revival in investment. Some sector rotation therefore is very likely.

Emerging markets seem to have run out of steam at the moment. There are huge problems in China and its first ever corporate bond default occurred last Friday. Commodity producers like Brazil are feeling the chill winds coming out of China. Geopolitical risk has hit Russia. Of the BRIC (Brazil, Russia, India and China) markets, India currently looks the best, especially given low commodity prices. Played right, it’s a big opportunity for India.

But will Modi be able to play it right? Fortunately, in the short term, it may not really matter. Long ago, economist John Maynard Keynes said the way to decide who would win a beauty competition was not to select whom you thought the prettiest woman, but to select the girl that most people believe is the prettiest. Keynes said that stock markets worked the same way. In the contest we’re having in India now, the market thinks Modi is by far the prettiest. In the long run, great expectations have usually led to disappointment.

Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com

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