Overheating of small-cap stocks brings fears of a downturn in the stock market

A rally in Indian equities that has swelled the market’s total valuation by $775 billion in a little more than five months has been accompanied by a notable shift in investors’ preference to smaller stocks. 

That poses risks as gauges of small- and mid-cap shares show signs of overheating, as the domestic economic outlook becomes more clouded ahead of national elections next year. 

Smaller companies are seen benefiting more from the ongoing recovery in India’s capital expenditure. Larger stocks, in contrast, have been relatively restrained by worry over the impact of a possible global recession on the nation’s major IT firms, as well as fallout from a short-seller campaign against the sprawling group controlled by billionaire Gautam Adani. 

The trend is the opposite to what has been seen in the US stock market, which has been driven by a handful of technology mega-caps surging on the boom in artificial intelligence, leaving small-caps in the dust. 

The Nifty Midcap 100 Index has risen 37 per cent from a March low, compared with a 16 per cent gain in the blue-chip NSE Nifty 50 Index, driving the ratio of the former to the latter to an all-time high. The previous such peak in early 2018 was followed by a drop of about 25 per cent in the midcap gauge over the next nine months, according to data compiled by the Bloomberg. 

The pace of gains in smaller stocks relative to large caps has raised caution about the near-term outlook for the latest uptrend in Indian stocks. “The outperformance is definitely getting into an extreme territory,” notes Sanjay Mookim, India strategist at JPMorgan Chase & Co. Midcaps have advanced even as earnings estimates stagnate, so “there is a natural limit” to how much further they can climb, adds Mr Mookim, who projects that the Nifty 50 will close 2023 down by 5 per cent. 

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