The stock market’s charge this week, propelling the benchmarks — the Sensex and the Nifty — to new lifetime peaks is accompanied by a tinge of irrationality. Foreign institutional investors, who are in the forefront driving the rally, appear to be placing their bets on political change and hoping this will make the economy and company earnings improve dramatically. The pattern in FII flows into India this year reflects how much these investors are staking on a strong NDA government taking charge at the Centre. They have ploughed almost $2 billion into Indian equity since mid-February, when Arvind Kejriwal stepped down as Delhi chief minister and ostensibly further strengthened the prospects of the market darling, Narendra Modi. A similar trend is evident in other emerging markets such as Indonesia and Thailand that are going to elect a new government this year; stocks in these countries have gained with foreign investors investing heavily in the past month.

Undeniably, the economic numbers reported since the beginning of this calendar have improved, reflected in the sharp decline in current account deficit, declining inflation and higher industrial output. But the overall picture is far from rosy. To begin with, the outcome of the election is far from certain. If a shaky coalition government is elected, then stock prices could decline as speedily as they are rising now. But even a pro-reform majority government would find it difficult to cut through the regulatory thicket that many industries find themselves caught in. For instance, there is little that the Centre can do to speed up projects delayed due to problems in obtaining environmental clearance or land acquisition permits. Many of the infrastructure stocks that have been quoting higher since mid-February are heavily debt-laden. Delays in project execution have played havoc with their cash cycle, making them struggle to service finance cost. With banks averse to lending to these companies, they are likely to struggle to complete pending projects.

Many of the foreign investors are hedge funds with very short-term investment horizons. Such hot money tends to drive stock prices higher in a speculative spiral before it is pulled out near the peak. Some funds are also purely event-driven with the mandate to bet on such things as election results. In 1999 as well as 2004, foreign institutional investors were net sellers in the month following the elections. In 2009, there was a large influx of foreign funds, but that was due to the US Fed’s quantitative easing and bargain hunting in stocks hammered in the 2008 crash. It would, therefore, be prudent to be cautious at the moment rather than follow the foreign investors blindly.

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