Dear Clients,
I shared three notes last year (2024), namely “Reality Check 1 & 2” in February-March 2024 and “Derivative Thinking” in July-August 2024. The central message of all three notes can be summarized below:
- Small and mid-caps are getting expensive, hence should be traded with caution.
- Certain sectors are showing bubble-like signs and should be avoided completely.
As you would find in those notes (and subsequent rise of the markets), the more cautious I became, the more markets went up in 2024. Small and mid-caps rallied more than their larger counterparts. It was like rubbing salt to my wounds. Finally, the wolves (or in this case bears) came. The markets have corrected as you can see from the last 1 year returns of various indices. Small & mid-caps have delivered zero returns.
| Index | 16-02-2024 | 14-02-2024 | Return % |
| BSE Sensex | 72708 | 75939 | 4.4% |
| BSE 500 | 31880 | 32465 | 1.8% |
| BSE Midcap | 40046 | 39731 | -0.7% |
| BSE Smallcap | 46011 | 45411 | -1.8% |
The correction has been severe in individual stocks, especially in small and mid-caps where the narrative (story) became so optimistic, it was difficult for the companies to deliver earnings growth expected by market participants.
Nothing Unusual:
If we go back to the history of financial markets, it is clear that corrections are part and parcel of equity investing. You cannot avoid corrections. It is a feature and not a bug. Most corrections begin sharply and eventually fade away. The same is true when the markets go up. Fair value itself is a nebulous concept, and it is futile to expect markets to remain in that zone always. What we have to remember is our own past experience. What does the past experience teach us? Well, it teaches us that “all past corrections look like an opportunity and all present or future corrections look risky.” It also teaches us that being reasonable at all times is the best way to navigate the markets. This is not a game of precision. You cannot say that the fair value of Sensex is 75939.997. No. It is always a reasonable range, and markets will keep on flirting with that range regularly. It is our recency bias that makes us bullish or bearish beyond reason. Otherwise, zero returns for 1 year is normal in equity markets.
The Way Forward:
Bear markets can be broadly classified into two types – Exogenous and Endogenous. Exogenous bear markets are caused by external factors such as COVID, Demonetization, Banking crises, etc. Here the fall is sharp and short lived. As government and other related agencies intervene and take care of the specific problem, the markets also revive to their previous levels.
Endogenous bear markets are caused by internal factors. Stretched valuations are usually the prime factor. In my note “Derivative Thinking”, I touched upon this concept. A sector does good, people get excited, valuations become expensive compared to the future growth the sector can deliver, eventually FOMO recedes, and the sector goes through price and time corrections. Endogenous bear markets are longer than exogenous bear markets because there is nothing the government or the related agencies can do. At least in the short term. The sector / market has to go through the necessary correction. Usually, it is both the price and time correction.
I believe we have seen price correction in large caps and larger mid-caps. Any downside here in large caps is not going to sustain and should recover quickly. We may not see fantastic returns in 2025, but the downside is protected from hereon. Mid-caps and small caps which were backed by narratives but lacked earnings growth will correct more. Probably we will see more time correction as compared to price correction.
The portfolio that is heavy on small and mid-caps (more than 40 to 50 percent) should be reviewed again and necessary changes should be made. Markets will become more reasonable going forward. Narratives will taper.
In conclusion, the sharp correction (especially in small and mid-caps) till now seems to be normal if we look at the history of equity markets. It is painful but normal. It is always good to remain invested in companies with good quality that are priced reasonably. More so in times like this.
