The returns of Indian stock indices so far this year have been seven times the average for emerging markets. These gains have made the Indian market more expensive than most comparable peers, and even developed ones like the US, UK and Germany.

The surge, on expectations of higher economic growth, has taken benchmark indices out of their bear market trough and placed them firmly in the fair-value territory or above, say experts.

"The Indian market is running very mildly ahead of fundamentals and valuations are not cheap, but they are not extremely expensive, either... The market is basically running on 2015-16 estimates and is hoping things will improve in that year. There is hope on improving macroeconomic conditions," said Vibhav Kapoor, chief investment officer, IL&FS.

Market experts, though, say that any disappointment on earnings or the reforms front, might raise the risk of exits by foreign investors, who have been the primary drivers of the latest bull run. They believe earnings growth of 15-20 per cent does not look impossible, but it is slightly optimistic. However, if the government takes policy action, leading to a pick-up in the economic momentum, 15-20 per cent earnings growth is possible; the markets can sustain in that case.

"With returns of over 40 per cent for most investors in a matter of a few months, the Indian market, without some significant positive news flow, might not be able to hold the weight of these levels over the next three months. There is more than 50 per cent possibility of a five-seven per cent correction by, say, January 2015. But the government can surely change this with some reasonable announcements on reforms
if that happens, it is fine," said Dalton Capital Advisors Managing Director U R Bhat.

So far, the government has largely taken corrective measures to put the economy back on the growth path.

Given that some state elections are due shortly and the code of conduct will come into force before those, it is to be seen whether the government will be able to announce big reforms that the market is looking forward to.

The BSE Sensex, meanwhile, has given returns of 31.64 per cent this year, way ahead of the 4.34 per cent average for Brazil, Russia, China, South Africa, South Korea and Mexico. Closest rival China has given returns of 14.28 per cent.

At the current level, the Sensex is trading at a multiple of 19.33 times its earnings, making it more expensive than benchmark indices in China, Brazil, Russia or South Africa. China is trading at a multiple of 11.48 times its earnings; the equivalent numbers for Brazil, Russia and South Africa are between six and 18 times.

But India's growth seems superior to peers' - except China, whose latest gross domestic product growth is 7.3 per cent, compared with India's 5.7 per cent. All other major markets are growing at rates below four per cent, slower than India. The latest GDP growth figure for Brazil is -0.87 per cent. In India, with inflation coming down, there are hopes of the Reserve Bank lowering the interest rate next year, enabling higher growth.

Slower growth rates are also true for developed markets, most of whom are trading at discount to India. Equity indices in the US, UK and Germany trade at price-to-earnings multiples between 10 and 16 times the earnings. Though France is trading at a P-E of 25.56, it has given negative returns of 2.47 per cent this year. The Japanese stock index is trading at 20.42 times its earnings after the country boosted its stimulus programme.

The US, China, Japan, Germany, France and the UK are the six largest global economies, according to World Bank data. The Indian stock market is more expensive than four of those. India is the 10th-largest economy in the world.

From its own historical perspective, though, valuations are far from expensive. The Sensex P-E, at 19.02, is not only much lower than the 28.57 recorded on January 9, 2008, but also below the 24.47 seen on October 13, 2010. And, as experts say, India should see a prolonged phase of strong economic growth, even higher market levels, if the right measures are taken.

What is worrying, though, is the significant rise in smaller stocks, many of which have surged 100-900 per cent in the past year. As a result, the BSE Midcap index is trading at P-E of 24.21 - slightly lower than 24.97 per cent, its highest figure in nearly a decade (recorded on September 22 this year).

"I do not know whether you can call it a bubble. The prices have gone up in anticipation of phenomenal earnings growth. Now, earnings growth has to happen (after disappointment in the first two quarters of this financial year)," said Dalton's Bhat.

"While the appreciation in the price of such (midcap) stocks looks unrealistic - because these were beaten down to very low levels - it is not a worrying sign. But, it is the second stage; when the first stage gets over, it depends on how the fundamentals catch up. If the results do not live up to expectations, such stocks will collapse," said Vibhav Kapoor.

One key factor that could significantly influence the Indian market is the FII mood. Foreign institutional investors have bought Indian stocks in large quantities in the past few months, driven mainly by political stability at the Centre and hopes around economic reforms. So far this year, they have pumped Rs 86,559 crore into Indian equities, helping many stocks rise more than the benchmark indices.

This was aided in part by the US Federal Reserve's so-called 'quantitative easing'. The programme made available cheap capital at low rates. Some of this money found its way into markets like India, which offered higher returns. This programme ended in October.

Though it has been said rates will continue to be low in the US, the move comes even as foreign ownership is at an all-time high, with more than a fifth of the total Indian stock market in the hands of foreign players. In fact, FII investments in many individual stocks have also reached or are closer to the permissible upper limits.

Motilal Oswal Financial Services Chairman & Managing Director Motilal Oswal admitted this posed a risk. "There is a risk of high foreign ownership, especially because there are few domestic large institutions (except Life Insurance Corporation) to absorb the outflows. While other central banks are still pumping in liquidity, the US is the largest source of funds for India," he said. FII investment flows could also see volatility led by geopolitical factors - the Ukraine crisis and a sharper-than-expected slowdown in Europe, among others. Though India is much better placed than last year, it cannot go unscathed from global factors, say experts.

Against this backdrop and given that there is little room for error, investors need to be a bit cautious from the short-term perspective.