A big question mark hangs over the sustainability of the on-going stock market rally that has already given benchmark indices a 15 per cent lift so far this year.

Some of the beaten-down sectors such as realty, banking and capital goods have risen up to 30 per cent, while power and auto indices have gone up around 20 per cent as foreign institutional investors’ money came in gushing at Rs 7,892 crore in just six weeks into the year.

But look a little deeper and you would begin to worry if it’s just a feel-good rally or a certain upward correction in valuations after the excessive selling over the past one year. For, there has not been much of a change in the fundamentals since November-December to create this exuberance. Most of the problems that haunted the market in 2011 have remained largely unaddressed.

There has been an improvement in the inflationary situation, but most economists have repeatedly warned that it’s only a minor blip largely due to a drop in food inflation. Crude prices have risen over the past few weeks, and a petrol price hike looks almost certain after the assembly elections.

The Reserve Bank of India has halted the interest rate hiking spree after 13 increases between March 2010 and October 2011, but nobody really expects a rate cut at least over the next two quarters. The rupee has recovered some 8 per cent from its 2011 close, thanks mainly to strong FII inflows, but it’s still at risk in view of ballooning fiscal and current account deficits.

The government has revised growth estimates for the financial year further downward to 6.9 per cent from its revised December forecast of 7.5 per cent. There has been no progress at all on the policy front, except for certain clarity on the 2G spectrum issue.

Industrial output recovered in November from a record slump in October, but it again slowed to 1.8 per cent in December due to sustained sluggishness in the manufacturing space and a decline in mining and capital goods sectors.

Globally, the picture continues to be mixed. While improving prospects in the US have given rise to optimism, the euro zone crisis continues to linger on and strong austerity measures across the continent now threaten to put pressure on major exporters, including India.

There is little doubt by now that the ongoing market rally has been driven almost single-handedly by FIIs. Domestic mutual funds have actually been net sellers of stocks to the tune of Rs 4,100 crore over the past one-and-a-half months.

“The recent FII inflow into India has been due to a combination of long-term refinancing operation in Europe, which has been beneficial for all global economies, and due to attractive valuations and high bond yields in the domestic debt market,” said Nimesh Shah, managing director of ICICI Prudential Mutual Fund.

Foreign investors also took the opportunity of weakness in the rupee to bring in dollars that flooded western markets following continuous monetary easing by the European Central Bank and the US Fed Reserve.

“The Indian market is quite strong, with excellent inflows from FIIs. Valuations were very reasonable in December. This attracted global investors into India. The CRR cut by RBI is giving a positive momentum to the market. Further, December quarter earnings suggest sales growth is still intact in India. All in all, the Indian market is now being seen as an excellent money making opportunities,” said Amar Ambani, head of research at IIFL.

But Morgan Stanley expects “Indian equities and credits to underperform their regional and emerging market peers during 2012 as the economy undergoes an extensive deleveraging process.”

Domestic brokerage Kotak Securities said it’s time for the market to consolidate its gains. “After this rally, valuations are reasonable given the moderate growth outlook in the near term. Looking ahead, developments in the euro zone would be monitored closely. Go-political developments related to Iran are also a matter of concern to us as it may push crude oil prices upwards,” it said.

The brokerage recommends stock picking with a bottom-up approach in IT, banking, media, logistics, capital goods and infrastructure sectors. “Such buys should be with a medium to long-term view,” it said.

The outlook may have turned a bit cautious for stock investors, but it’s definitely not a lost case.

“Amid the constraints, positive cues continue to provide optimism. Factors such as a downward bias in interest rates and the focus on growth could provide some tailwind to the economy. The biggest positive is that the home-grown challenges are within India’s control,” said Shah.

He said many mid-caps and small-caps are positioned for further upside. “Bottom-up stock picking is what we believe will generate alpha for our investors in this environment,” Shah said.

Religare Capital Markets suggests three themes to play in the mid-cap space from here on; rate-sensitive stocks, bombed-out stocks with decent business fundamentals and stocks with continued earnings growth with reasonable valuations. The brokerage has identified Allahabad Bank, Yes Bank, Union Bank and Mannapuram General Finance in the first category; Satyam, Prestige Estates and Crompton Greaves in the second category and Marico, Hexaware and SKF India in the thid. .

bijoysankar@mydigitalfc.com