MUMBAI/BANGALORE (Reuters) - Indian shares are expected to extend their rally and gain almost 5 percent by year-end, spurred by optimism that fiscal and economic reforms show the government is determined to mend the economy and regain the confidence of foreign investors.
But after an almost 21 percent rise so far this year, the Indian stock market is not cheap. A sharp domestic slowdown, and uncertainty about the global economy could prevent Indian shares from rising much higher.
The 30-share BSE Sensex will rise to 19,500 points by the end of 2012, according to the median forecast from a survey of 20 investment houses conducted over the past week, and then rise further to 20,400 by the middle of next year.
End-year projections for the Sensex which closed on Wednesday at 18,632.17 points, ranged from 17,000 to 20,500.
The new end-year forecast is higher than the 18,750 points expected in the June poll, but that is partly a reflection of how much the market has rallied since then.
Back then, the government's ability to pass reforms was in doubt and India was facing the threat of a sovereign ratings downgrade and sharply slowing economic growth.
But now, analysts are more optimistic.
"Expectation of a reform juggernaut to rev up growth is likely to keep markets on a roll," said Vivek Mahajan, head of research at Aditya Birla Money, a securities firm. Mahajan expects about a 4 percent rally by December, like many others.
The forecasts are upbeat even though India's main index is already Asia's second-best performing index this year, beaten only by Thailand's SETI, and is on course to rack up its biggest year of gains since 2009.
Despite a strong January, the performance of Indian shares had fizzled out by May as economic growth slowed to below 6 percent, well under the near-double-digit clip in the mid-2000s.
However, the government has changed direction since the summer, with the appointment of P. Chidambaram as finance minister. Foreign investors have bought close to $15 billion of Indian stocks so far this year, after net outflows of about $500 million last year.
The index has climbed 7 percent since June in the run-up to this month's European Central Bank's plan to buy bonds to bring down borrowing costs of Spain and Italy, and the U.S. Federal Reserve's third round of bond purchases, dubbed QE3.
But the poll showed that although the end-year target for the index has jumped to 19,500 from 18,750 in the June poll, the mid-2013 target is the same at 20,400 points.
This month, India delivered a range of long-anticipated economic reforms, including a hike in subsidised diesel prices, despite strong political opposition.
But analysts say more is needed.
"Industry confidence is required to be restored for investment. Funding and approval bottlenecks need to be addressed," said K.K. Mital at Globe Capital Market in Delhi.
Fifteen of the 16 poll respondents expect the government to stick to its reform agenda. Both Standard & Poor's and Fitch Ratings lowered India's sovereign debt outlook to "negative" earlier this year and Delhi is keen to prevent any cut.
Although reforms alone are not the key factor for these credit ratings agencies, 11 out of 16 of those polled said India would avoid a credit rating downgrade.
The BSE Sensex was significantly undervalued at the start of the year compared to historic averages, but the gap is narrowing. Australian bank Macquarie estimates the MSCI India index is trading at 14.3 times fiscal 2012/13 earnings, compared to 9.7 times for the MSCI China or 12.3 times for the MSCI Asia Ex-Japan index.
Polling by Ashrith Doddi. Editing by Jane Merriman