The Indian stock market has been witnessing a remarkable rally, especially in the small-cap sector. The Nifty Small Cap Index has seen an impressive surge of 20.5% in the last quarter, hitting an all-time high. This performance has left investors and market watchers both exhilarated and cautious. Is this rally sustainable, or are we due for a market correction? Let's delve deeper.

The Small-Cap Rally

The small-cap sector's rally has been nothing short of extraordinary. The Nifty Small Cap Index's performance has outpaced the broader market, with the Nifty rallying by 10.5% and the Nifty Mid-cap index up by 19% during the same period. This rally has been fueled by robust earnings growth, with an expected growth of 12-14% for FY24. The current earnings season for the June quarter has been particularly strong, with Nifty companies likely to grow earnings at 25% year-over-year.

Valuation

The valuation of the Nifty, which represents the large-cap segment of the Indian stock market, and the small-cap sector, can provide insights into the overall market sentiment and potential investment opportunities. As of the last quarter of 2023, the 1-year forward Price to Earnings (PE) ratio of the Nifty stood at 20.2x, well above its long-term averages, indicating that large-cap stocks were relatively expensive. This could potentially lead to a short term time and price correction in the markets, on the other hand reason for cheer in the market like macroeconomic stability, earnings momentum, global recovery are also plenty.

On the other hand, the small-cap sector, despite its recent rally, has historically traded at a discount to the Nifty. However, the recent rally has narrowed this discount significantly. While small-cap stocks are expected to grow earnings faster in a rising economy, the sharp rally in the small-cap sector has led to concerns about overvaluation.

Small-cap valuations have gone bonkers in previous rallies and the valuation right now is nowhere near the top. This suggests that while there may be potential for further growth, investors should be cautious and consider the possibility of a market correction.

History of Rallies and Corrections in Small Caps

The Indian small-cap sector has seen several periods of significant rallies and corrections over the years. Here are some notable periods:

1. Rally during 2003-2007: This period was one of the longest bull runs in the history of the Indian stock market, and small-cap stocks were no exception. The BSE Small-Cap index rose from around 1,300 points at the beginning of 2003 to nearly 13,000 points by the end of 2007, marking a ten-fold increase.

This period was marked by strong economic growth in India, driven by robust domestic demand, increased foreign investment, and significant infrastructure development. The Indian government implemented several economic reforms during this period, which boosted investor confidence and led to a surge in the stock market, including the small-cap sector.

2. Correction in 2008: The global financial crisis led to a severe correction in the Indian stock market, including the small-cap sector. The BSE Small-Cap index fell from its peak of nearly 13,000 points in late 2007 to around 3,000 points by early 2009, losing about 75% of its value.

The global financial crisis, triggered by the collapse of Lehman Brothers, led to a severe correction in global stock markets, including India. The crisis led to a liquidity crunch, reduced foreign investment, and a slowdown in domestic economic activity, which hit small-cap stocks particularly hard due to their higher risk profile.

3. Rally during 2014-2017: The small-cap sector saw a significant rally during this period. The BSE Small-Cap index rose from around 5,000 points at the beginning of 2014 to nearly 20,000 points by the end of 2017, marking a four-fold increase.

This rally was driven by positive investor sentiment following the election of a new government in India in 2014, which promised economic reforms and infrastructure development. Additionally, low global interest rates during this period led to increased foreign investment in emerging markets like India.

4. Correction in 2018: The year 2018 saw a significant correction in the small-cap sector. The BSE Small-Cap index fell from nearly 20,000 points at the end of 2017 to around 13,000 points by the end of 2018, marking a loss of about 35% of its value.

The correction in the small-cap sector in 2018 was largely due to concerns about overvaluation following the previous rally, as well as tightening global liquidity conditions. The US Federal Reserve started increasing interest rates during this period, leading to capital outflows from emerging markets like India.

5. Rally during 2020-2021: The small-cap sector, like the rest of the market, saw a significant rally during this period, recovering from the lows caused by the COVID-19 pandemic. The BSE Small-Cap index rose from around 10,000 points in March 2020 to nearly 23,000 points by the end of 2021.

The rally during this period was largely a recovery from the sharp market drop caused by the COVID-19 pandemic in early 2020. The unprecedented fiscal and monetary stimulus measures implemented by governments and central banks worldwide, including India, to combat the economic impact of the pandemic, led to a surge in liquidity and boosted investor sentiment, driving a strong market rally.

Why are the markets rallying now?

The current rally in the Indian stock market, particularly in the small-cap sector, can be attributed to several factors. Firstly, robust earnings growth has been a key driver. The expectation of an earnings growth of 12-14% for FY24 has fueled optimism among investors. Secondly, the Indian economy is expected to be one of the best performing globally over the next few years, which is attracting both domestic and foreign investors.

Furthermore, global fund managers continue to be bullish on the Indian markets. India has now overtaken China as the most attractive Emerging Market for investing in Emerging Market debt, according to a survey by US Invesco. This bullish sentiment is driven by India's improved business and political stability, favorable demographics, regulatory initiatives, and a friendly environment for sovereign investors.

Lastly, the market rally has been supported by the accommodative monetary policy of the Reserve Bank of India (RBI) and the government's proactive measures to stimulate economic growth. However, it's important to note that market rallies are influenced by a complex interplay of factors, and the factors mentioned above are some of the key contributors to the current rally.

Learn more about the top small cap stocks to invest in 2023.

Could the market correct now?

Given the recent rally in the Indian stock market, particularly in the small-cap sector, the question of a potential market correction is a valid concern. The Nifty's 1-year forward Price to Earnings (PE) ratio is currently well above its long-term averages, suggesting that large-cap stocks are relatively expensive. Similarly, the small-cap sector, despite its historical tendency to trade at a discount to the Nifty, has seen this discount significantly narrow due to the recent rally. These factors, combined with concerns about rising inflation in India and potential changes in global monetary policy, suggest that the market could be due for a correction. However, predicting the exact timing of a market correction is notoriously difficult. It's important for investors to maintain a diversified portfolio, stay focused on their long-term investment goals, and be prepared to weather potential short-term market volatility.

Conclusion

While the small-cap rally has been a boon for investors, it's crucial to approach the market with a balanced perspective. Given the current market dynamics, it might be prudent for investors to stagger their investments and use any market dips as buying opportunities.

While the long-term outlook for the Indian market remains positive, the near-term rally in small caps suggests that waiting for better entry points during market corrections could be a wise strategy. As always, a diversified portfolio and a long-term investment horizon remain key to navigating the ebbs and flows of the market.

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Four-Year Milestone: Revolutionizing Investments

As we mark our four-year anniversary at Wright Research, we're celebrating our journey of innovation, resilience, and growth. Four years ago, our founder, Sonam, started with a dream of democratizing quantitative investing. It was a journey that began with a passion for quant finance, algorithms, and transforming investment strategies. Today, we're proud to say we have not just disrupted the investment landscape, but we're also innovating it.

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Launching Wright Portfolio Management Service

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At Wright Research, we are dedicated to pushing boundaries, challenging norms, and leveraging the power of technology to ensure the best for our valued investors. As we take this momentous step, we invite you to join us on this exciting journey. Stay tuned for a special AMA session next Sunday 6th August, 2023 with Sonam Srivastava and Rakesh Rathod from Smallcase, where we will celebrate our anniversary, answer your questions, and discuss the future of Wright Research. Join us in the celebration, and let's continue to disrupt and innovate together.