Thanks to the recent rally, now the index is more expensive than it was at 2014-end or when it hit a life-time high in January.
The Indian stock market has been one of the top gainers in a global recovery in equities after deferment of the US Federal Reserve rate hike in September.
The benchmark BSE Sensex is up 10.4 per cent from this year's low (hit on September 7), making it the fourth best performing market in the current rally after the Hong Kong, South Africa and Shanghai markets.
Most of the gains, however, came via a further expansion in the index valuation, rather than a growth in underlying earnings.
The Sensex is now more expensive on a trailing price to earnings multiple than at the end of the 2014 calendar year or when it hit a life-time high in January this year.
This, the analysts say, caps the upside unless corporate earnings in the September quarter matches with the rise in valuations.
"The market is running ahead of fundamentals in the sense that corporate earnings have not kept pace with the rise in stock prices. This could create some volatility in the short term if the second quarter (July-September) earnings turn out to be below par," says G Chokkalingam, founder and chief executive officer, Equinomics Research & Advisory.
The analysis is based on close of the day index valuation ratios. Index underlying earnings per share (EPS) is calculated by inverting its reported daily price to earnings multiple.
At Friday's close, the index was trading at a 22.1x its underlying EPS in the trailing 12 months, higher than its PE multiple of 19.3x at the end of December 2014 and 20.9x on January 29, when the index closed the day at a new life-time high.
Sensex earnings multiple (P-E ratio) is up 12 per cent since its September low. Only the South African market has witnessed a steeper rise in valuations (12.6 per cent). In comparison, the Sensex underlying EPS was down 1.6 per cent during the period.
Now, all hopes are on an earnings recovery in the second half of the current financial year and beyond.
"My clients are not worried about the current earnings season as it's expected to be bad. What matters is whether the Sensex EPS would be higher in October next year from the current level and I am pretty sure India Inc will start delivering soon," adds Chokkalingam, who manages wealth (mostly in equity) for high net worth individuals.
He expects a swift recovery in earnings once the dust settles due to a favourable base effect next year.
The Sensex's underlying EPS is down 12.4 per cent during the first 10 months of the current calendar year, providing a favourable base for corporate earnings in FY17 over FY16.
The September quarter earnings season has started on a cautious positive note for bulls.
The combined net profit of eight Sensex companies is up 13.5 per cent over a year for the quarter.
It has translated into an earnings growth of 1.7 per cent on the trailing 12 months.
Some analysts, however, question the sustainability of the early bird results, given the flat to negative growth in sales volume and revenue.
"Profitability in second quarter was led by lower raw material costs but gains from lower commodity prices will peter in the next two quarters. A sustained growth in earnings requires a secular rise in demand, not visible on the horizon," says Dhananjay Sinha, head of institutional equity at Emkay Global Financial Services.
According to him, the rally is purely driven by benign liquidity flows after no-rate hike by the Fed and the 50 basis points cut in the benchmark rate by the Reserve Bank of India last month. One basis point is one-hundredth of a per cent. "There is exuberance in the market and fundamentals such as GDP growth and corporate earnings don't matter in the near term," he adds.
This should, however, be a caution for investors who wish to buy and hold stocks for the long term, as the adjustment could be sudden and sharp.
