MUMBAI (NewsRise) -- A bout of nationalistic fervor has driven the Indian stock market to new highs by improving Prime Minister Narendra Modi's chances of returning to power in the general elections and raising hopes of further reforms.
But the swift, sharp rally, fueled by foreign funds, could soon come up against political and economic realities, say some observers, who point to tepid data and the market's rich valuations as reasons to take money off the table.
The selloff could be steep if Modi's Bharatiya Janata Party fares less well than expected because earnings growth is unexciting, MayBank Kim Eng Securities said in a recent report.
Most opinion polls expect the National Democratic Alliance, the group of parties led by the BJP that is now in power, to win the elections albeit by a slimmer margin than in 2014. While the BJP won a majority on its own five years ago, its tally is also expected to weaken. However, the party has fared much better in recent surveys.
Approval for the business-friendly Modi has soared since late February, when he ended a standoff with Pakistan after a suicide-bombing attack with decisive action.
The incident softened the perception of the BJP as national security, rather than its illiberal stance, became the standout issue. Foreign investors have since returned to the market, lured by the prospect of policy continuity.
Other factors have helped. The U.S. Federal Reserve has relaxed its stance on rates, driving more funds to emerging markets, while domestically, the Reserve Bank of India has cut policy interest rates twice in the past three months to kickstart the slowing economy.
Since March, foreign inflows into Indian stocks have totaled $7.2 billion, among the largest across seven emerging Asian markets. That's well above the $4.8 billion worth of Indian stocks that foreigners dumped last year amid the bad-debt crisis at banks and the implosion in the non-banking sector.
The benchmark Nifty index of 50 stocks, which underperformed the MSCI's index of Asia Pacific shares outside Japan in the first two months of the year, turned best performer in March with a gain of 7.7%. The index hit a record high of 11,856.15 points on April 18 and has since hovered in a narrow range.
The surge, driven by technology and automakers' stocks, has fueled index valuations. The MSCI India 12-month forward price-to-earnings valuations are at 18 times, which is about a 40% premium to the Asia-Pacific index.
The gains in certain groups of stocks are a red flag, say some.
"If you look at the growth and employment metrics, and high-frequency data like auto sales and electricity consumption, a slowdown is underway. It is better to exit than invest right now," said Varun Khandelwal, director at Bullero Capital.
In the three months ended December, India's growth slipped to 6.6%, its slowest pace in five quarters, as consumer spending lost momentum.
Passenger vehicle sales, a barometer for demand, grew at their slowest pace in five years in the year ended March. Recent data show demand for electricity is cooling even as oil prices rise.
Khandelwal expects the focus to return to macroeconomic factors soon after the election results, which are due on May 23.
Should Modi return to power, he will have to deliver on the populist pledges worth more than $25 billion that he made in the February budget to please various vote banks, straining finances.
Then there are the realities of leading an administration that includes other parties. A resounding mandate in 2014 helped Modi push through reforms such as the introduction of the Goods and Services Tax and a bankruptcy and insolvency law. But he made little headway with controversial measures relating to land and labor. This time, he may face greater challenges, especially if his party doesn't fare well and he is forced to rely more on the support of his allies.
Some investors see corporate earnings as driving the market's performance.
"The market is hopeful of an earnings revival," after a weak year when the problems in the financial sector rippled into other areas, said Mayuresh Joshi, fund manager at Angel Broking. "If earnings start to disappoint, it'll be hard to sustain premium valuations," he said.
Average earnings growth forecasts for this fiscal year range between 14% and 27%, supported by hopes of a recovery in the performances of banks.
After results for the third quarter ended December were announced, brokerage Motilal Oswal cut its current-year earnings estimate for the Nifty 50 companies by 3%.
The brokerage cited growing losses at telecom companies and declining margins at automakers and oil-marketing firms.
--Dhanya Ann Thoppil and Dipika Lalwani