Firstly, the growth numbers are exaggerated because it was achieved on a small base last year. The year-ago quarter was a washout and most companies saw their earnings take a dive because of a severe contraction in demand, inventory losses due to a crash in commodity prices, and mark-to-market losses arising from a weakening rupee. This quarter, growth returned to normalcy but the picture appears rosy only due to the comparison with an exceptionally bad quarter.

Secondly, the sectors that came back on track do not inspire confidence in future growth. The big growth in the past quarter was seen in automobiles (passenger cars and two-wheeler), cement and metals apart from software services. The disappointments came in banks, the lifeblood of an economy; commercial vehicles, a lead indicator of economic growth; real estate and telecom. Consumer and pharmaceuticals showed steady growth, but that is not good news as they have been resilient even in bad times. Infrastructure has been a mixed bag but the miserable performance of Larsen and Toubro has splashed cold water on buzzing infrastructure stocks.

Ironically, metals and software services are a function of global factors and given that recovery out there is still hazy, it may not be too wise to extrapolate into the future. For automobiles and cement, the key driver was the stimulus package. Auto sales perked up on account of low interest rates, excise duty cuts and most importantly the spending gush post the release of the 6th pay commission arrears while cement was up on good volumes and duty cuts.

So the question is how long can this growth momentum sustain? In India, though the size of direct stimulus measures at $10 bn (0.8 per cent of GDP) has been modest in comparison to say a China where the stimulus package is pegged at $586 bn (13.3 per cent of GDP), the overall government spending in the recent past has been very strong. Between October 2008 and September 2009, government consumption in India increased by 29 per cent in real terms as against the historic average of 4.5 per cent.

While that might have been the right move to restore business and consumer confidence, the government’s going slow on spending will have an impact on growth if private spending does not step up. So far there are no signs of the latter happening. The investment cycle has been on the downswing since fiscal 2007 and growth in investments in the September 2009 quarter at 1.9 per cent was the lowest in the last eight years. Nilesh Jasani of Credit Suisse believes that earnings projections for FY11 will be met if and only if private sector investments pick up and foster economic growth.

Analysts are counting on an earnings growth upwards of 20 per cent for the next fiscal. While the first two quarters of FY11 may see some growth again because of a relatively modest numbers same period this fiscal, there may be little for markets to cheer. Stock prices have already factored in possible upgrades.

As a matter of fact, over the past six months, earnings upgrades have been a key factor in keeping up the momentum. Since April 2009, Sensex earnings estimate for 2011 have been marked up almost 30 per cent.

The bigger risk to earnings estimates comes from commodities companies failing to deliver. Analysts forecast that around 45 per cent of the Sensex earnings growth in 2011 will come from global commodities, which heavily depends on how sustainable the global recovery is. Then, inflation and the onset of an early interest rate tightening cycle also pose formidable market risks. While it may be reasonable to expect earnings upgrades going forward, the extent of revisions most probably is not going to trigger a significant re-rating of stocks.

This then brings us to the point on valuations. Currently, the Sensex is trading at 17 times 2011 estimated earnings ahead of its long-term average of 14 times. And then the fact that stocks have already run-up significantly and there is hardly any pocket where stocks look grossly undervalued means that there is little room for disappointment on the earnings front.

There is another key risk that the market may not be appreciating at this point. And that is, the possibility of the massive supply of paper (around $7-8 bn including PSU disinvestments) which could absorb the available liquidity capping gains in the secondary markets.

The harsh reality is while the argument for India’s long-term growth story remains strong, with sectors focused on domestic consumption expected to do well, the current valuations give little room for comfort. With most of the near-term positives priced in, the market remains vulnerable to negative surprises and clearly, investing in 2010 will be a lot more challenging than it was in the year gone by. Here is a review of how various sectors fared in the past quarter and how they are poised.