Stock markets optimistic post state poll results. Are the valuations justified?

This Hindi belt accounts for around 12% of total Lok Sabha seats, and the BJP's performance in these three states has raised expectations of the party retaining a majority in the upcoming general elections and allayed concerns of political uncertainty and policy instability.

Reflecting this positive sentiment, the BSE Sensex hit an all-time high of 68,918.22 and the Nifty50 scaled a new peak of 20,702.65 on Monday.

However, investors should exercise caution as state election results have not always shown a correlation with Lok Sabha polls, said Motilal Oswal Financial Services. For instance, BJP had lost these three states in December 2018, but won the 2019 Lok Sabha elections with a better majority than in 2014.

Local issues predominantly influence state elections, while economic growth takes center stage in general elections.

This time around, state elections were marked by welfare schemes/freebies, particularly those targeting women and girls. The free handout strategy may continue in the run-up to the general elections and could keep state finances under pressure.

“Investors were worried that a poor showing by BJP in state elections would increase the risk of more fiscal populism," said a Nomura Global Markets Research report dated 3 December. “As such, the actual results should calm such fears, although a BJP victory across most states does not necessarily reduce the likelihood of competitive populism recurring as a dominant theme into the 2024 general elections, in our view," its economists added.

On the bright side, stocks of companies with rural and healthcare exposure may benefit from the welfare schemes. Oil marketing companies might also see an improved earnings outlook with the reduced likelihood of retail fuel price cuts. Midcaps, smallcaps, and PSU stocks are expected to see a positive rub-off as well.

Despite the reduced political uncertainty and the easing of crude oil prices, corporate earnings need to catch up to justify India's high valuation multiples.

The MSCI India index is trading at a one-year forward price-to-earnings of 21 times, showed Bloomberg data. This is a premium to MSCI Asian Ex-Japan and MSCI Emerging Markets indices.

Foreign fund inflows are also expected to strengthen with the risk of political uncertainty likely reducing. Plus, crude oil prices have eased from recent peaks, putting India on a relatively firmer footing. Thus, this valuation gap is likely to sustain.

While no steep downgrades are expected to FY24 earnings estimates, meaningful upgrades are also unlikely without an improvement in demand.

To be sure, the Nifty50 has given decent returns in the past ahead of general election outcomes. That said, the general election is still some months away and any political shift could derail the momentum.

Meanwhile, investors will keenly watch the Reserve Bank of India’s monetary policy meeting scheduled this week. The central bank is largely expected to maintain a status quo on interest rates and retain its withdrawal of accommodation stance. “Despite a correction in retail inflation in the past three months, a rebound in selected perishables and ‘stickier’ food components like cereals and pulses are likely to push inflation back towards 6% this quarter," said Radhika Roa, senior economist, DBS Bank in a note.