Mumbai: Indian shares rose to their year-high on Thursday and closed at their highest in 19 months as investors rushed to buy stocks on renewed optimism, after foreign direct investment into the nation jumped 60% in the first eight months of this fiscal year and the government on Thursday gave large state-run companies more operating freedom to help them become globally competitive.

The 30-share Sensex, the benchmark index of Bombay Stock Exchange, gained 129.50, or 0.8%, to close at 17,360.61. The broad-based 50-stock Nifty of the National Stock Exchange rose 0.7% to 5,178.40.

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With Thursday’s gain, the Sensex has risen 80% this year, and is set to log its best yearly gains since 1991. It has outperformed a 71.6% rise in MSCI’s Emerging Market index and a 31.5 % rise in the MSCI world equity index.

From the year’s low of 8,069 in March, the Sensex has surged nearly 113%. Only Russia, Sri Lanka, Indonesia and Brazil have given better returns to investors in 2009.

With the government projecting 7.5-8% economic growth in current fiscal and analysts expecting handsome corporate earnings in the third quarter ending December, the growth momentum in markets may continue in 2010, said analysts.

Core infrastructure industries grew by 5.3% in November against a meagre 0.8% a year ago, in line with the recovery in industrial growth.

“The corporate earnings growth for the third quarter is expected at 30-35%. The earnings could be even higher for the fourth quarter. This will keep the growth momentum up for equity markets," said Manish Sonthalia of Motilal Oswal Financial Services Ltd.

Infosys Technologies Ltd, the infotech bellwether, will kick off the earnings season on 12 January.

Continued short covering and fresh buying from large institutional investors took the Sensex to its year high on Thursday after a 3.23% gain on Wednesday.

Short covering is a phenomenon where traders buy equities to close an open short position. This is done by buying the same type and number of securities that were sold short. Most often, traders cover their shorts whenever they speculate that the securities will rise.

Foreign institutional investors or FIIs bought stocks worth Rs707 crore, according to provisional figures from the National Stock Exchange.

FIIs have bought Indian shares worth $17.13 billion during the year, approaching the record $17.78 billion (Rs83,210 crore) of net inflow in 2007.

According to V K Sharma of domestic brokerage HDFC Securities Ltd, the growth numbers of India appear more realistic than that of China and other emerging markets, and this will help in attracting more foreign fund flows into Indian equities during 2010.

Money always chases opportunity and now the opportunity is in India, said Jagannadham Thunuguntla, chief strategist at SMC Capitals Ltd. “There are not many options left for the global investors." Even domestic institutional investors such as mutual funds have pumped in big money this year, buying stocks worth Rs26,606 crore so far.

Such buying has pushed the prices of smaller stocks higher, with the BSE Midcap index returning 105.29% year to date, and the small cap index rallying 120.5%.

But every fund manager is not comfortable with the phenomenal rise of stocks this year. On a cautious note, Anand Shah, head of equities, Canara Robeco Asset Management Ltd that manages Rs8,193 crore worth of assets, said: “After a 100% rise, we have to be cautious. People are getting into low quality, highly leveraged companies and making money. But the margin of safety is very limited."

The Sensex is currently trading at a price to earnings or P-E multiple of 22.25 times, against its historic average P-E of 13.8 times. A recent Credit Suisse report mentioned that if earnings growth were to accelerate further, there could be a P-E rerating to 17.5, which would see the return of a “growth premium". This could mean Indian markets touching 22,000 levels by 2010 end.

Despite the prospects of withdrawal of the government stimuli in the forthcoming Budget and a rise in interest rates, optimism is ruling the street. Better earnings growth outlook, implementation of government’s divestment policy and rush of more foreign funds are the factors behind the optimism.

FDI into India increased to $19.4 billion in the eight months starting April, according to government data released on Thursday. Foreign investors have been attracted by India’s economic growth.

Indian state-run companies will be able to make purchases in the country or overseas of as much as Rs5,000 crore, the government said in a statement on Thursday. Listed state-run companies with average annual sales of more than Rs25,000 crore in the last three years will become eligible, the government said.

“We expect 2010 to be a positive year for Indian equities, driven by improving GDP (gross domestic product) and earnings growth and supportive government action on the reform front," said the Credit Suisse report dated 16 December.

“Accelerated divestment of public sector enterprises, partial deregulation of the oil sector, and insurance/pension sector reform are some of the key agenda items that are expected to be addressed in 2010. This would send a positive signal to investors and can attract significant capital flows into the country," added the report.

The most critical challenge that the Indian market will face in 2010 is rising inflation. A recent Deutsche Bank report on India’s 2010 outlook said, “Three major themes for 2010 would be—supporting acceleration in growth while managing inflation, bringing the fiscal position under control and pursuing growth critical structural reforms."

Global rating and research agency, Standard and Poor’s, sees 2010 as a turning point, characterized by overall prudence among market participants amid a tepid recovery in mature economies and guarded optimism among emerging markets."

With the market rising three days in a row, the gains in a holiday-shortened week has been 3.8%, its biggest weekly gain in six weeks. Markets are shut on Friday and Monday for holidays.

Graphics by Sandeep Bhatnagar/Mint

Ami Shah of Reuters and Rajhkumar K. Shaaw of Bloomberg contributed to this story.