Beyond the Index: Should Small Cap and Mid Cap Investors Be Worried?

When one is deeply immersed in a herd mentality they are often unaware of their conformity until they are exposed to a contrasting perspective. On the other hand, changing your perspective as soon as you get exposed to a contrasting viewpoint makes you indecisive. More often than not investors Sea-Saw between being a herd follower to being indecisive. We are witnessing this same phenomenon taking place.

Nifty Midcap 100 and Nifty Smallcap 100 have surged by 34% and 38% respectively in the past 6 months as against a 17% rise in the Nifty 50. The Midcap 100 PE went to 25.48 in July from a low of 21.68 in March. The market participants were enjoying this euphoria and their confirmation bias was giving this rally all kinds of good names. Slowly some murmurs of fear and discomfort started to erupt and boom Nifty Midcap and Nifty Small Cap indices witnessed their biggest single-day fall of the year on 12th September. Suddenly the herd followers started being indecisive, the “Everything is right” answers turned into “Is everything right” questions.

So do the Nifty Small-Cap and Mid-Cap indices have more room to grow? In my humble opinion, the question and this approach to picking stocks is itself wrong. This question comes from an evolutionary process of generalization. Brain generalizes things basically to save time. However, the generalizations also lead to being unjust to the nitty gritty of the things.

Before the Midcap and Smallcap indices had captured the headlines, it was the PSU stocks that were the talk of the town. The BSEPSU index has gained an impressive 31.2% in one year. There was some sort of a narrative that PSU Stocks can’t go wrong. However, if you had randomly picked PSU stocks you could have gained poor returns despite the index performing well. That’s because it was the Defense, construction, and Banks that had outperformed whereas the refineries, Life Insurance, and Fertilizers had reported subdued returns.

Let's go to the 2018-2019 period which was one of the worst periods for the Small Cap 250 and Midcap 150 index where they saw a fall of 27% and 13% respectively. Despite this steep fall in this period, there were 17 Small Cap 250 stocks and 18 Midcap 150 stocks that generated returns of greater than 20%. In fact, there were 3 stocks in Small Cap 250 and 4 stocks in Midcap 150 which gained a massive return of more than 50%.

Similarly, after the decline observed on September 12th, 2023, both the Nifty Midcap 150 and Small Cap 250 indices have not yet completely bounced back. However, there are 26 stocks within the Nifty Midcap 150 and 54 stocks within the Small Cap 250 that are now trading above their September 11 highs.

A Blanket generalization might have caused you poor returns during the PSU Rally and would have made you miss big returns during the 2018-2019 Mid and Small-cap downfall. The rise and fall of various market indices tell only part of the story, and relying solely on such generalizations can be a misguided approach to stock selection. History has demonstrated time and again that not all stocks within an index or sector move in unison. Each stock carries its unique narrative, influenced by a myriad of factors, including industry trends, financial health, management decisions, and broader economic conditions.

Hence, instead of being concerned about the performance of the midcap and small-cap indices, investors should prioritize evaluating the performance of their individual stocks without applying a group perspective.

Technical Outlook

Nifty gave a higher close for the second consecutive week and ended at 20,192, up 372 points. The Index took 37 trading sessions to go past the previous all-time high of 19,992 made on July 20, 2023. While the Nifty's momentum has tempered after reaching new peaks, the prevailing positive trend remains firmly in place.

The Long-Short Ratio stood at 65.06% on 14th September on the back of Foreign Portfolio Investors (FPIs) trimming their short exposure in Index futures during the week. Despite the price making higher highs, the Put-Call Ratio (PCR) has been making lower highs since last three days having fallen from 1.52 on 13th September to 1.49 on 15th September, indicating put writers’ unwillingness to build positions at fresh highs.

Nifty found resistance around the 20,170 levels in the current week and the maximum call open interest is placed at 20,200 Strike. A strong close above 20,200 with short covering support will help Nifty gain the lost momentum. On the downside, the level of 20,000 is expected to act as a strong support and provide a good opportunity to buy on dips, should profit booking ensue from the prevailing levels in the forthcoming week.

Indian IT Sector is Ready for an Upmove

India's primary strength in the global tech landscape has been its IT services sector. The Indian IT sector faced turbulence with IT companies underperforming in Q4FY23 due to factors such as delayed spending, fears of a global economic slowdown, and revised revenue guidance. But now there are indications of a recovery. The Nifty IT index, which had declined by 14 percent between April 1, 2022, and August 31, 2023, has shown signs of improvement since September 1, 2023, with a 4.11 percent increase.

One critical factor in this recovery is the reduction in attrition rates reported by IT companies during Q1FY24, signifying improved knowledge retention and cost savings from reduced employee turnover.

Furthermore, major Indian IT firms have secured multi-billion dollar IT services deals in recent months, bolstering their revenue prospects for the remainder of the year.

As we enter the second half of the year, several factors shed light on why the Indian IT sector is displaying signs of reversal and the potential beginning of a rally. Let us have a look at some of these factors.

A significant drop in US CPI Inflation may result in heightened interest in IT services, as businesses become more inclined to invest in technology and digital transformation endeavors. Consequently, this could contribute to improved profit margins for leading Indian IT companies.

The below chart illustrates a decade-long analysis of Nifty IT, showcasing a comparison between its returns in the first six months and the latter half of each calendar year. The IT index exhibited superior performance during the latter half in 7 out of 10 years. The average return in the first half of a calendar year from 2013 to 2022 is 3% and in the second half is 17%.

The question arises: will this trend persist in the second half of the calendar year 2023?

The following chart depicts the performance of the Nifty IT index and the Nasdaq 100 index up to the present moment. These two indices have a correlation of 0.95 which suggests a strong positive linear relationship between them.

Currently, the Nifty IT index is underperforming or lagging behind the Nasdaq 100 index. As the Indian IT sector shows signs of recovery, it is reasonable to anticipate that the Nifty IT index will gradually converge towards the Nasdaq 100 index in the coming months.

The Nifty IT index is presently trading at a Price-to-Earnings (PE) ratio of 27, closely aligned with its 5-year average PE of 26. This figure is notably lower than its all-time high PE of 37.

Investors should focus on prominent Indian IT majors that are currently undervalued. As the index gains momentum, the companies with cheap valuations could spearhead the market rally.

Technical Outlook

Nifty moved in a higher high formation throughout the week and closed at 19,820, up 385 points. The Index is just 172 points away from the all-time high of 19,992, made on July 20. The Future Open Interest (OI) indicated a buildup of long positions in Nifty futures for all five days during the week.

The volatility cooled off in the current week as India VIX ended the week 5.15% lower at 10.78, giving major comfort to the bulls. The Foreign Portfolio Investors (FPIs) built long positions in Index Futures during the week as the Long-Short Ratio moved from 51.77% on 4th September to 56.89% on 7th September. Nifty consolidated in the 19,250-19,600 range for 24 trading sessions before breaking out of the range during the week and gave a higher close on the weekly chart for the first time in six weeks.

Nifty closed marginally below the 78% Fibonacci retracement level on 8th September, which is placed at 19,830 levels, drawn from the high of 19,992 made on July 20 to the low of 19,224 made on 31st August. Nifty looks poised to breach its all-time high of 19,992 soon. The level of 19,700 will act as immediate support for Nifty, being the maximum put open interest strike. This level presents a good opportunity to capitalize on potential market dips, should profit booking ensue from the prevailing levels in the forthcoming week.

Gearing up for More: Midcaps and Smallcaps Rally to Continue

Last year, I told you that Smallcaps can bring bigger profits in 2023. While the broader index Nifty50 has rallied 6.34% in 2023, the Nifty Midcap 100 has surged 24.15%. The Nifty Smallcap 100 has outperformed both the indices, boasting an impressive 25.82% return.

We had mentioned about how the Nifty Smallcap 100 Index rebound next year after falling in a calendar year. There have been only 5 instances since 2005 where the Nifty Smallcap 100 has given a negative return. However, in the following year, the index yielded a return of above 30% barring a single instance in 2019.

The chart below shows the yearly returns of the Nifty Small Cap 100 index. In 2022, the Smallcap index fell 11% and notably, the year 2023 has witnessed a remarkable resurgence, with the index rising by more than 25% in just 8 months.

After a relentless streak of advancement spanning 5 consecutive months, the Nifty50 index cooled off in August 2023. In contrast, both the Nifty Midcap 100 Index and the Nifty Smallcap 100 Index have stayed buoyant, making record highs with each passing day.

So where are the markets headed? Will the rally continue? Will Nifty continue its uptrend? Do smallcaps have room to outperform?

Let’s do some data-crunching.

The Nifty50 index rallied continuously for 5 months from March’23 to July’23. Since 2010, there have been only 4 instances where the index has rallied continuously for 5 or more months.

As shown in the table below, the Nifty50 has yielded double-digit returns in all of these periods with the average return being 23.08%. In the next 6 months, the broader index enters a consolidation phase giving modest returns of 0.58%.

Let us see how the Nifty Midcap 100 Index and the Nifty Smallcap 100 Index return during the same period.

The Nifty Midcap 100 Index and Nifty Smallcap 100 Index have always outperformed the Nifty50 index surging on an average by 30.50% and 30.80% respectively. However, unlike the Nifty50 index which enters a consolidation phase, the Nifty Midcap 100 and Nifty Smallcap 100 indices continue their upward rally, soaring 6.30% and 8.10% in the next 6 months.

This time again, the Nifty50 index has rallied for 5 continuous months, with the Nifty Midcap 100 and Nifty Smallcap 100 indices outperforming the broader index. In August’23, the Nifty50 yielded a negative return of 2.53% while the Midcap and Smallcap continued to soar by 3.70% and 4.62% respectively.

Drawing comparisons, it seems that the Nifty Midcap 100 and Smallcap 100 would continue their trajectory of upward movement.

Therefore, this is still a favourable time for investors to invest in small and midcap stocks. However, investors should exercise due diligence in scrutinizing not only financial metrics, but also the governance structures, board composition, and disclosure practices. This holistic evaluation would enable investors to safeguard their capital and optimize their portfolio returns.

Technical Outlook

The Nifty50 consolidated in the 19,250-19,450 range throughout the week and closed at 19,435, up 170 points. Following five consecutive weeks of closing in the red, the Nifty index concluded the most recent week with a positive gain, closing in the green.

The volatility cooled off the current week as India VIX ended the week 5.94% lower at 11.36, giving minor comfort to the bulls. The Foreign Portfolio Investors (FPIs) showed promising signs of bulls coming back as the Long-Short Ratio moved from 40.42% on 25th August to 50.50% on 31st August, indicating that the FPIs now marginally hold more long positions relative to short positions in Index Futures. Nifty tested the 50-Day Exponential Moving Average of 19,295 on the daily chart six times in the last fourteen trading sessions and managed to close above it on Friday. The Index has given a higher close and formed a morning star pattern on the daily chart, which is considered to be a bullish reversal signal. The maximum call open interest for Nifty is placed at 19,500 Strike. Short covering at 19,500 Strike with a follow-up move from Friday’s closing of 19,435 will lead to the bulls coming back in Nifty. On the downside, the level of 19,300 will act as a strong support and a breach of the same can drag the Index to 18,900 levels, where its next visible support is placed.