How To Cope With The End Of The Mid-and Small-Cap Rally?

If you are still overweight on mid- and small-cap funds, book profits. Thereafter, sit tight and ride out the downturn

- Sudipta Mitu

The rally in mid- and smallcap stocks began in 2012 (see table). Since then these stocks have consistently given positive returns to investors. But now it appears that the rally may have ended. Year-to-date the S&P BSE Midcap Index is down 11.53 per cent while the S&P BSE Smallcap Index is down 14.05 per cent.

Why has the rally ended? 

After giving positive returns for almost six years, the valuations of mid- and smallcap stocks had become very expensive. Normally, large-cap stocks trade at a premium to mid- and small-cap stocks. Earnings of the latter tend to decline dramatically during an economic downturn. Earnings of quality largecaps tend to be more resilient in such circumstances. Due to this attribute, in ordinary circumstances, the market gives a higher valuation to largecaps stocks than to mid- and small-cap stocks. But after the recent rally, valuations of mid- and small-cap stocks had turned much more expensive than those of large-caps. On January 8, 2018, for instance, the 12-month trailing price to earnings (P/E) ratio of the Nifty Midcap 50 Index touched the highest level of 99.91. In comparison, the Nifty 50 touched the highest level of 27.81 on January 23, 2018. The Nifty Smallcap 50 touched a mind-boggling PE of 1,160 on April 19, 2018 this year (source: NSE). Such astronomical valuations, and the premium vis-a-vis large-cap stocks, was clearly unsustainable. This made the correction in these stocks inevitable.