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Is Investor Optimism Over Indian Stocks Out of Whack?

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Indian equities have had a bumper year, surging more than 25 percent year-to-date, driven by foreign inflows and optimism surrounding the government's recent reform action, and strategists expect the euphoria to spill into next year, forecasting gains of up to 20 percent for stocks in 2013.

Banks including Standard Chartered and Morgan Stanley predict the benchmark Bombay Sensex will breach its lifetime high of 21,206 hit in 2008 by the end of next year supported by easing in domestic monetary policy and positive earnings growth. The former sees the index reaching 22,000, while the latter forecasts it will touch 23,097 – marking a rise of 14 percent to 19 percent from current levels.

However, given that growth in Asia's third largest economy is looking to come in at a below-trend 6-6.5 percent next year, together with a volatile currency and the threat of a credit rating downgrade, are these investor expectations out of whack?

"In the near term, there isn't a real trigger for the market – valuations are no longer hugely attractive and the rupee is no longer massively undervalued," PK Basu, managing director and chief economist at Daiwa Capital Markets told CNBC.

A cheaper rupee has attracted foreign investor flows into the market. Foreign institutional investors make up around 28 percent of market turnover, according to data from Kotak Securities, and this year foreign inflows touched over $20 billion, the second highest since their entry into Indian capital markets in 1992. In 2010, over $29 billion entered the market, while last year there was a net outflow of $358 million.

However, the currency has strengthened more than 4 percent against the dollar since hitting a record low in June and this could impact foreign inflows. Plus, the heavy involvement of foreign players in the market could be a double-edged sword, as a bout of risk aversion or a pullback in global liquidity could lead to heightened volatility for Indian stocks.

( Top Performing Currency in 2013? Not What You Think )

Getting Pricey

Also, Indian stocks have become expensive compared to their peers. The Sensex is trading around 14.5 times forward earnings, up from 12 times a year ago. Major regional markets including China's Shanghai Composite and Japan's Nikkei 225 are trading at 11 and 12.5 times forward earnings, respectively.

"Valuations have become fairly expensive for most stocks, domestic consumption related plays in particular are trading above their historical averages," said Sanjeev Prasad, senior executive director at Kotak Institutional Equities. Big companies in the consumer space including ITC and Hindustan Unilever, for example, are trading at forward price to earnings ratios of 26 and 31, respectively, considerably higher than their historical averages of 22 and 26, said Prasad.

"For other sectors including IT and metals, which depend on the state of the global economy, I don't think you can expect upside earnings surprises there. 2013 doesn't look like it's going be a great year in terms of growth," he added.

Prabhat Awasthi, head of equity research, Nomura India, who is underweight the country's stocks, agrees the market is overly optimistic on its earnings expectations for Indian corporates next year.

For the fiscal year 2013-2014, the market expects earnings growth of about 15 percent for companies that make up the index, said Awasthi, who however, sees earnings growth coming in lower at 10-11 percent.

"We don't think there will be an earnest earnings recovery… economic growth will bottom out next year, but there won't be massive growth," he said. In this fiscal year that ends in March 2013, earnings growth for the 30 companies that make up the Sensex will come in at 5 percent, much lower than initial estimates of 18 percent, according to Nomura.

Awasthi argues that current stock prices have already priced in a revival of capital expenditure activity – a big driver of economic growth – but investors will likely be disappointed.

"Policy announcements made by the government so far are not significant enough to spur investments meaningfully in the near term," Awasthi added, noting that there is a two-year lag between project planning and execution.

In September, the Indian government allowed foreign investment into the retail, aviation and broadcast sectors in the hope of kick-starting the economy, which has seen growth languish around 5.5 percent this year, a far cry from the 8-9 percent growth rates seen just a few years ago.

Morgan Stanley India equity research head, Ridham Desai, on the other hand, believes the market will be powered by earnings growth of 19 percent next year, helped by improving money supply growth, lower interest costs and slowing pace of commodity price increases.

According to Desai slower global growth would impact commodity prices, helping tame inflation and benefiting corporate margins. "We think that earnings growth is likely to improve over the next 4-6 quarters," he said.

Eye on Reforms

Beyond corporate earnings, one factor that will be critical to investor confidence next year is economic reforms.

While the government has stepped up initiatives to boost growth and trim its deficit, a continuation of reforms next year is pivotal to holding up the positive sentiment, said analysts.

(Read more: India Declares, 'We're Back in Business' )

"We've seen a rise in FDI (foreign direct investment) limits in a few sectors but barring that nothing much has changed. What is key is whether the political system is conducive for more reforms to tackle structural problems in the economy," Prasad said.

In the year leading up to the general elections in 2014, some analysts fear that the government may turn more populist. The country's 2013-2014 budget, due in March, will provide a clear indication of how far the government is willing to go with reforms.

Fund manager Sameer Arora of Helios Capital, who sees India's 50-share Nifty index moving up 10-20 percent next year, is confident that the reform momentum will carry on, pointing to the government's success in getting the parliament to vote in favor of FDI in multi-brand retailing on December 7.

Lower Borrowing Costs

Barring political headwinds, Clive McDonnell, strategist at Standard Chartered, projects the equity market will be in for a solid year in 2013, supported by interest rate cuts, which will reduce the cost of capital, as well as from easing inflationary pressures - a positive for profit margins. The bank, which is overweight on India, forecasts the Sensex will rise over 14 percent next year.

Standard Chartered economists expect inflation in India to moderate from 7.8 percent in 2012 to 6 percent in 2014, providing room for policymakers to reduce rates by up to 100 basis points in the year ahead.

The Reserve Bank of India on Tuesday held the benchmark interest rate at 8 percent, as expected, but indicated that it would shift its focus towards supporting growth as inflationary pressures ebb.

(Read more: What Will It Take for India to Cut Rates? )

Further monetary easing in the West and in Japan, which is expected to embark on an aggressive easing program under its new leader Shinzo Abe, will lead to more inflows into Indian equities, said analysts.

"We forecast foreign portfolio inflows (into emerging markets) to increase to $42 billion (in 2013). Flows will particularly benefit India, which has a higher than average reliance on foreign portfolio inflows," said McDonnell.