Nifty Midcap and Smallcap indices fall over 10% from recent peaks, enter correction territory

Investors continued to pull funds from mid- and small-cap stocks for the fifth consecutive trading session on Wednesday, November 13, as reflected by the significant declines in both the Nifty Midcap 100 and Nifty Smallcap 100 indices, which dropped an additional 2% today.

The ongoing pullback in these counters signals that the downturn is far from over, with market sentiment remaining cautious due to poor Q2 earnings, a slowdown in high-frequency economic indicators, rise in retail inflation and persistently high valuations.

The Nifty Midcap 100 index dropped 2.23% in today’s trading, hitting a low of 54,024. Over the past five sessions, including today, the index has fallen by 5.5%, resulting in an 11.32% decline from its record high of 60,925, reached in late September

Similarly, the Nifty Smallcap 100 index fell 2.53% to a day’s low of 17,535. Over the last five days, the index has declined by 7.18%, and it has now lost 10.71% from its all-time high of 19,640, achieved on September 6. This rapid decline has pushed both indices into correction territory, which is defined as a 10% drop from a recent high.

The recent slump in these segments follows a period when mid- and small-cap stocks garnered significant attention, driving their valuations to extreme levels. Analysts have raised concerns about the steep valuations, particularly as these stocks were seen as more affordable alternatives to large-cap stocks.

The sharp fall in the broader market can primarily be attributed to heavy selling by foreign portfolio investors (FPIs) since late September. This shift in investor sentiment coincided with a rally in Chinese shares, which gained momentum after a series of central bank stimulus measures in late September sparked a buying frenzy.

While foreign investors have turned bearish on Indian stocks, domestic institutions have stepped in, pouring billions into the market to absorb the selling pressure. Despite these efforts, the market continues to slide sharply, indicating substantial ongoing selling pressure.

Is this the right time to focus on large caps?

DSP Mutual Fund, in its latest Netra report, reveals a notable shift in market dynamics, indicating that large-cap stocks are beginning to outperform small and mid-cap stocks. The report points out that, since COVID-19, mid- and small-cap indices have outpaced large-cap indices, as reflected in the rise of the midcap/Sensex and smallcap/Sensex price ratios.

Currently, the Midcap index is trading at its highest relative level compared to the Sensex, while the Smallcap index is near its peak since 2005. This suggests that the small and mid-cap space has outperformed large-caps and is now at one of its most expensive relative levels.

“The 12-month rate of change now shows early signs of reversion, hinting at a potential mean reversion period, which may make larger-cap indices an attractive option. Large caps also appear relatively favourably valued now, though overall market valuations remain above average or expensive,” said DSP Mutual Fund.

Why India outperforms over the long term?

India’s long-term outperformance is often explained through narratives like domestic flows or high GDP growth. However, according to DSP Mutual Fund, these are merely surface-level explanations.

“The fundamental question is why stock investors should expect higher returns than those offered by bonds. The extra return that stocks can provide stems from the ability of management to generate returns exceeding their cost of capital. Therefore, the primary driver of stock prices over the long term is the returns that shareholders earn on their capital. Companies with superior return on equity (ROE) are more likely to deliver higher returns compared to their peers,” said DSP Mutual Fund.

DSP Mutual Fund points out that India ranks second only to the U.S. in the number of firms consistently achieving an ROE of over 20% for more than a decade. This strong ROE performance is the true engine behind India’s superior stock market results, highlighting that the underlying fundamentals, rather than popular narratives, are what truly drive long-term market success, it said.

Disclaimer: The views and recommendations given in this article are those of individual analysts. These do not represent the views of Mint. We advise investors to check with certified experts before taking any investment decisions.