Yet the Sensex has doubled since March and the bull case is amply priced into current market metrics. The Sensex is somewhat extremely expensive at 17 times forward earnings and higher inflation will mean a RBI tightening and a liquidity squeeze in the money markets. A rise in the inflation rate has meant a toll in the Sensex in almost every case since the Rao/Chindambaram market reforms in the summer of 1991. In any case, as the Congress government will exit the stimulus policies of 2008, excise duties and interest rates could rise at the same, hardly a bullish scenario for earnings, economic growth or the Sensex. I have long argued that the India rupee was set to surge (since August when the spot rate was near my entry point of 48.80) and can easily envisage a 43-44 rupee rate in the next eight months. This will be acceptable to the RBI as a higher rupee will help to dampen crude oil import related inflation, particularly if the Peoples Bank if China allows appreciation in the Chinese Yuan.

The RBI will have no choice but to hike the banking system’s cash reserve ratio and lending rates and Brazil style capital account restrictions are not unthinkable to repel hot money. Bank lending rates could then rise as high as 8 per cent as credit demand revives, leading to a sharp fall in government securities prices. The Indian economy’s Achilles heel is its fiscal black hole, with New Delhi’s fiscal deficit an unconscionable 11 per cent of GDP. Political risk is no longer a significant issue in India as Congress has checkmated the BJP in the last general election and jettisoned its Lok Sabha allies from the Left Front. This is surely positive for the cause of banking, insurance, pension fund reform and privatization of state owned companies.

While the macro case for Indian equities is still positive, the valuation case is ambiguous at best. Valuations were at rock bottom at 8000 last autumn in the immediate aftermath of the Lehman Brothers catastrophe. Yet the market’s parabolic run since March has totally erased any vestige of undervaluation.

Even as returns on shareholder equity for Indian companies fall, the Sensex trades at almost three times book value. Indian shares are far more richly valued than their peers in China, Brazil, South Korea, GCC, Taiwan or Russia. This means the Sensex a hostage to the mood swings of the liquidity driven global emerging market at a time when EM fund managers are clearly overweight the blue chips of Dalal Street. Of course, the secular (if short term brutally fickle!) overweight by FII investors for Indian equities is matched by an embryonic domestic insurance and retail mutual fund investor underweight that will only broaden the appeal of the market but cannot insulate it from short term FII capital outflows.

I am also worried about the impact of recent bond yields, retail NPL and RBI mandated provisions on Indian bank earnings. I believe we are on the brink of the correction in the Sensex that could take a market down 2500-3000 points, making 14000 Sensex a superlative entry point.

I doubt if we hit 18000, let alone the January 2008 high of 21600. So my base case scenario is that the Sensex will trade between 14000 and 18000 in the next twelve months. Voila!

This is not to argue that investors should not remain vigilant about the prospects of attractive growth sectors. The Indian government’s infrastructure spending will triple to $450 billion in the next four years, with plans to literally double the existing power generation capacity the largest component. This makes BHEL a clear winner as it has the best gas turbine/generator product pipeline and order book of any engineering firm in India, far higher than Larsen Toubro, Suzlon, Nagarjuna or ABB. Yet I would not touch BHEL now as current valuations are stratospheric at 25 times earnings and an unjustifiable 17 times price to book with an enterprise value/EBITDA ratio of 15.

The Indian pharmaceutical industry is another attractive investment sector, given the secular growth in the US generics markets, speedier FDA approvals and the prospects for custom product manufacturing. Dr Reddy has been my sector favorite in Indian Big Pharma. With the BSE information technology index having more than doubled since March, I am convinced that it is dangerous to hold the shares of Infosys, Tata and Wipro at current levels. Dell’s earnings shock and SAP/IBM management updates suggest that next year global IT budget growth will be mediocre. Moreover, the rising rupee will hit Indian software.

The psychotic contrarian in my soul gravitates towards Indian telecom fallen angel Bharti Airtel, whose shares were gutted since its October high of Rs562 to only Rs280 now. Bharti shares slumped when it slashed roaming charges in November but management believes demand curves is highly elastic and roaming usage will surge. Indian telecom shares have plunged 30-40 per cent due to a tariff war and Bharti, once a growth stock favoured by fund managers, now trades at a modest 12 times fiscal 2011 earnings estimates. Yet Bharti has the cost curves, economies of scale and balance sheet prowess to survive the tariff. While revenue and earnings and earnings growth will be flat for the next six month, I want to buy Bharti at Rs240 for a 400 target.

Views expressed by the author are his own and do not reflect the newspaper’s policy.