Since the publication of our initiation report dated 3 September, Indian equities (as represented by MSCI India Index) have rallied 12.09% in rupee terms and 18.94% in dollar terms.

While such performance is rather impressive on a stand-alone basis, it is really low on a global emerging markets relative basis.

During the noted period, Indian equities, as represented by the MSCI India Index, have outperformed their global emerging market peers, as represented by the MSCI EMF Index, by 4.33%.

Photo: Abhijit Bhatlekar; graphic: Yogesh Kumar / Mint

Between the September and January, Indian equity market was one of the world’s largest net recipients of foreign capital inflows.

During the relevant period, global macro landscape turned disproportionately friendly to Indian equities as the dollar recorded a sharp rebound compared with the euro during December. The Indian rupee strengthened significantly against the dollar and other major currencies.

We attribute Indian market’s unimpressive relative return performance during the September and January period primarily to lack of strong valuation support.

Specifically, in contrast to the first quarter of 2009 (a period during which Indian equity valuations hovered at exceedingly large discounts compared with their global and global emerging market peers), current valuations render Indian stocks unattractive as compared with their global peers. Indian equities now trade on a 12-month forward price-earnings multiple of 17.5x against a 14x average for the asset class.

However, Indian equities’ uniquely strong medium- and long-term earnings growth visibility leads us to expect only a marginal relative return underperformance over the short term.

The Indian equity market’s short-term relative return performance outlook is likely to be conditioned by the pace of foreign capital inflows into emerging markets over the ensuing period.

That India’s economy and equity markets are especially vulnerable to sudden reversals in global liquidity conditions towards emerging markets is a well established fact.

An added risk factor likely to impede Indian equities’ relative return outperformance over emerging markets stems from interest rate hike scenarios by the Reserve Bank of India, likely to be fuelled by mounting inflation readings in the months ahead.

We enter 2010 with a highly defensive positioning at the stock and sector levels, based on our global macro assessments as well as the Indian market’s ample discounting of solid growth for the balance of 2010.

As noted above, we believe that the Indian market is bound to consolidate following a pace of inordinately large foreign capital inflows into the share market. We believe more opportune investment entry levels in Indian equities will be forthcoming in the weeks and months ahead.

These considerations lead us to raise cash levels to 4%, reinforce our underweight recommended allocations to cyclical sectors, such as metals, autos and realty as well as banks, on the back of our global and India macro baseline case and valuation considerations.

Telecom sector weighting has been lowered from overweight to equal weight owing to lack of near-term catalysts and an increasingly challenged competitive landscape for the sector.

Technology and cement sectors are upgraded from equal weight to overweight (in the case of information technology, or IT) owing to rising earnings visibility for global IT spending, the sector’s incremental metamorphosis into a global geographical footprint and attractive valuations.