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Wild ride ahead for Indian equity investors

If history is anything to go by, equity investors in India are in for a wild ride in the days and months following the general elections which conclude on May 16.

Following the most recent election in 2009, when the Indian National Congress (INC)-led coalition won an overwhelming victory, the benchmark S&P BSE Sensex returned 20.5 percent in the five days after the election. By contrast, in 2004, when the Bharatiya Janata Party (BJP) lost the elections, the index declined 16 percent in the five subsequent days.

"Past experience shows that elections can be harbingers of significant post-election volatility," Nomura strategists led by Prabhat Awasthi wrote in a report on Tuesday.

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However, in the months after the elections, the market ultimately tends to reflect economic realities, notes Awasthi.

For example, market losses after the BJP's 2004 loss eventually turned to gains as the improving economy overtook the initial disappointment. The market rose 14.5 percent in the nine months after the elections. In 2009, meanwhile, the market continued to rise as the economic recovery continued after the global financial crisis, returning 40 percent in the nine months after the elections.

So what should investors expect this time around?

A win by the BJP-led National Democratic Alliance (NDA) will likely lead to a positive knee-jerk reaction, followed by sustained gains through the remainder of the year, forecasts Nomura.

Recent opinion polls have shown the opposition BJP, led by Prime Ministerial candidate Narendra Modi, holding a strong lead, which has gotten investors excited given Modi's more business friendly stance. The party has promised to recharge the economy, improve infrastructure, quicken oil and gas exploration and reform the tax system to attract investors.

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The bank's current year-end target for the Sensex is 24,700 – 10.5 percent higher than current levels. It sees the possibility of 5-10 percent further upside from this level if the NDA forms the government with a strong BJP plurality.

Indian stocks, which last month recorded their best monthly gain since October, have risen 6 percent since the start of the year.

"Our positive stance on the market is driven not by a positive view on the growth recovery, but by an expected reduction in macro stress beyond market expectations," Awasthi said.

"The first of these, a reduction in the current account deficit, has largely played out. We also believe that inflation will remain under control. If anything, a strong government could facilitate this process through higher fiscal discipline in the short term and increased emphasis on the supply side in the longer term," he added.

If the BJP-led NDA does not win enough seats to build a wider majority coalition, this would be a "negative shock" for the markets, Awasthi noted.

"Investor disappointment would likely mean large capital outflows, resulting in a resurgence of balance-of-payments pressure. The sovereign credit rating could be downgraded as credit risks are likely to re-emerge," he said.

HSBC, which is underweight Indian equities, holds a more cautious view on the implications of the elections for the market.

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"It continues to be the most loved market in the region and has received large FII [foreign institutional investors] inflows, which have stretched valuations to above average levels," said Gary Evans, global head of Equity Strategy at HSBC.

"This puts the market at risk, given that the growth outlook remains fragile on the back of fiscal tightening, high inflation, elevated corporate leverage, and rising NPLs [non-performing loans] in the banking sector," he said

The bank expects the Sensex will end the year lower from current levels. It has a year-end target of 21,750 for the index – 3 percent below current levels.