Smallcaps slip into 'correction' zone; index down 10% from February

The drop in the smallcap index comes even as the benchmark Nifty logged a fresh record high in an earlier session

The National Stock Exchange Nifty Smallcap 100 Index on Tuesday slipped into ‘correction’ territory amid the market regulator voicing concerns about rich valuation and warning against the formation of bubbles.

A fall of 10 per cent or more from a recent high is termed ‘correction’.

Declining close to 2 per cent for a second day, the Nifty Smallcap 100 hit an intraday low of 15,011, shedding 1,681 points, or 10.1 per cent, since logging an intraday peak of 16,692 on February 8. The index is still up 62 per cent in the past year.

The 10 per cent drop in the smallcap index comes even as the benchmark Nifty logged a fresh record high in an earlier session.

Since February 8, the smallcap and largecap indices have seen divergent trends, with the former underperforming by nearly 12 percentage points.

While concerns around expensive valuations had already forced some investors to take profit off the table, market regulator Securities and Exchange Board of India’s (Sebi’s) recent diktat to mutual fund (MF) houses to initiate steps to rein in the excesses in the smallcap space has knocked the wind out of their sails, say market observers.

“There are pockets of froth in the market; some call it a bubble. It may not be appropriate to allow that bubble to keep growing because when it bursts, they impact investors adversely. What should the industry do to not keep fuelling the bubble? MF trustees should formulate a policy to manage this risk,” said Sebi Chairperson Madhabi Puri Buch at an event on Monday.

Last month, the regulator asked MFs to put in place an investor protection framework for smallcap and midcap fund investors amid building up of “froth” in this space.

Some industry players believe Sebi’s signalling is hurting sentiment and is the reason behind the recent divergent performance and weakness in smallcap stocks. However, some say the kind of fresh inflows that were coming to smallcap schemes, it was prudent for Sebi to sound a note of caution.

“There is some merit in the argument that it’s not the regulator’s place to comment on valuations. But if there is some froth in the smallcap space and it ends in a steep correction, the small investor loses money, and the regulator is concerned about that. Eventually, the stock price is decided by demand and supply. The regulator is only concerned about whether you have created an artificial demand. Such rallies don’t end very well for retail investors; therefore, as a proactive regulator, Sebi is trying to ensure that there is an orderly market,” said U R Bhat, co-founder, Alphaniti Fintech.

A report by ICICI Securities on Monday highlighted how equity valuations were turning “uncomfortable” as the increase in prices isn’t commensurate with the growth in earnings.

“The Nifty 50 has gained 31 per cent from March 2023 lows, as against a trailing earnings expansion of about 18 per cent during the same time. The broader market price rise is even higher compared to their earnings expansion with mid/small/microcaps returning 62 per cent/73 per cent/100 per cent, since March 2023 lows,” said ICICI Securities strategist Vinod Karki and Niraj Karnani in a note.

According to the brokerage, the price-to-earnings multiples have expanded by nearly 50 per cent for the Nifty Smallcap 100, indicating high earnings growth expectations.

Foreign brokerage Nomura this week said regulatory crackdown is a risk that needs to be monitored. The Reserve Bank of India and Sebi are trying to remove some exuberance from the financial system while ensuring banks and other players have a better handle on potential risks, it said.

Nomura said small and midcaps are more vulnerable than their larger peers as regulatory actions affect domestic fund flows.

Some see India’s regulatory crackdown as parallels with China, which in early 2015, banned the nation’s three biggest security brokerages from opening new margin trading accounts for three months.

“While we do not think India’s case is similar to China’s in 2015, these developments are noteworthy, given signs of exuberance in some parts of the market,” said the Nomura note.