Mumbai: Indian equities have seen a re-rating in the past few weeks owing to a sudden surge in foreign inflows that lifted benchmark indices and strengthened the rupee. The premium for local stocks has risen sharply, surpassing the five-year average historical premium over global peers.

Improving global risk appetite and abundant liquidity, especially in Europe, have led to a turnaround in emerging markets, benefiting India. The current phase could be a temporary rise rather than the beginning of a bull run as economic fundamentals still look grim.

Graphic by Paras Jain; photograph by Hemant Mishra/Mint

After falling 25% in 2011 on a weakening economy, the Sensex, BSE’s benchmark equity index, has seen a rapid jump this year, rising nearly 15% and recovering much of last year’s loss. The 7% rise of the rupee against the dollar makes the Indian market appear even more attractive to global investors.

Yet, the valuations are not as attractive as earlier. The benchmark index now trades at 15 times estimated earnings for the fiscal year ending March, compared with 13 times in December. Although the Sensex is still trading below its five-year average price-earnings multiple of 17 times, the rise in the ratio has been sharper this year relative to its peers.

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The Sensex has traded at an average premium of 35% over MSCI Asia (excluding Japan) in February so far, 13 percentage points higher than its historical premium over the past five years. Similarly, the Sensex’s premium over MSCI Emerging Markets has widened by 10 percentage points to 47%. The Sensex’s premium over MSCI Asia and MSCI Emerging Markets had shrunk to 17% and 33%, respectively, by the end of 2011.

The sharp rise in the Sensex this year has come at a time when consensus earnings estimates are still being cut, widening the forward price-earnings premium. The consensus earnings estimates of Sensex firms for the current fiscal have fallen 8% to Rs1,148 per share since the start of the fiscal year.

In the same period, consensus earnings estimates for fiscal 2013 have dropped 13%. Net profit of 25 Sensex firms that have so far declared December quarter earnings grew 3.99%, after growing 16.25% in the April-September period.

Official estimates of gross domestic product (GDP) growth have also been pared down to 6.9% from 9% earlier. Fundamentals are likely to deteriorate further in the next fiscal as slowing economic growth crimps sales, affecting profitability, said Anish Damania, head of institutional equities, Emkay Global Financial Services Ltd.

Sales growth for the broader market is expected to fall to 15-16% in fiscal 2013 compared with 23-24% in fiscal 2012, which will lead to lower earnings growth, as costs will remain elevated, Damania added. “This not a beginning of a bull run, since the fundamentals are deteriorating,” said Damania. “Rather, it is an extended bear market rally.”

Nevertheless, the sharp rise of the Sensex driven by foreign inflows worth nearly $4 billion has taken most analysts by surprise, and the current level of 17,748 points is close to or higher than the year-end targets of most brokerages. Damania pointed out that Indian markets are shallow and the inflow of foreign investments worth $3.9 billion this year has caused the rally.

The surprise intervention of the European Central Bank (ECB) has led to the unforeseen rally and the sustenance of the rally will depend on additional monetary easing, said Saurabh Mukherjea, head of equities, Ambit Capital Pvt. Ltd.

Analysts say monetary easing by the ECB has whetted risk appetite as the liquidity problems of Europe have been addressed even though insolvency still remains an unresolved issue. Mario Draghi who took over the reins of the ECB in November has since then lowered the benchmark interest rate to a record low of 1%, eased collateral rules, and loaned European banks an unprecedented €489 billion ($642 billion) for three years at the benchmark rate.

As banks continue to remain tight-fisted in giving loans, some of the additional liquidity has found its way into riskier assets, boosting equities and commodities across the globe. The rising tide of liquidity has so far benefited battered-down markets and stocks more than others.

Indian markets saw the best January in 15 years and are till date among the biggest gainers in Asia. Other Asian markets such as Hong Kong, South Korea and Singapore, which saw big declines last year, have also made smart year-to-date gains of 9-12%.

However, as Citigroup Inc.’s emerging markets strategist Geoffrey Dennis pointed out in an 8 February note, the “January effect” is of little value in signalling the direction for the year to follow and is a better indicator of the year that just finished. The beginning of the year is a time for rotation when beaten-down stocks are picked up by investors, Dennis added, citing the evidence so far this year.

Even within the Indian market, stocks that were hammered down badly in 2011 have been among the leading gainers. For instance, the leading gainers among Sensex firms this year, Tata Motors Ltd, Tata Steel Ltd and Sterlite Industries (India) Ltd, which have all moved up by more than 40% this year, had fallen between 35% and 51% in 2011.

Although additional liquidity may continue to favour emerging markets, it may be a double-edged sword for India as crude prices will also tend to rise.

“Too much liquidity can drown us too,” Sanjeev Prasad, an equity strategist at Kotak Institutional Equities, wrote in a 7 February note.

The rise in crude oil prices will add to inflationary pressures and widen the twin deficits—fiscal and current account. Crude prices have already shot up 12% this year to $117 a barrel.

In the near term, cues from Europe will determine the direction of markets, analysts said. Uncertainty over the Greek bailout package spooked investors across the globe on Friday, indicating that markets could have a volatile ride ahead, as long as the European sovereign debt problem remains unresolved.

pramit.b@livemint.com

Ashwin Ramarathinam and Ravindra Sonavane contributed to this story.