The dream rally in mid and small-cap stocks might be at its end as both midcap and smallcap indices witnessed a sharp decline with 90 percent of the stocks closing lower, recording the biggest single-day fall of this year. The Indian stock market witnessed a divergence of over three percent between Nifty and Midcap index, biggest in three years.

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The Nifty Midcap 100 index settled at 40,170.30, down 3.07 percent or 1,273.90 points, while the Nifty Smallcap 100 index plunged 4.10 percent to close at 12,450.20 in trade Tuesday.

The Nifty Midcap and Nifty Smallcap indices have surged almost 27 percent and 28 percent, respectively, so far in 2023 as against a 10 percent rise in Nifty. Both these indices have outperformed benchmark indices for the seventh straight month in September.

Meanwhile, in the last one year as well, the Nifty Midcap and Nifty Smallcap indices have rallied nearly 24 percent each, compared to a 10.64 percent jump in Nifty50.

Sandeep Tandon of Quant Capital believes mid-caps and small-caps will likely see profit-booking in the near term as euphoria is witnessed in certain pockets. Investors may shift to large-caps, he stated.

What should investors do now?

After a mad rally that started at the turn of the new fiscal year, retail investors have made mouth-watering returns, across the board, especially in the midcap, small cap and micro cap categories, said Omkar Kamtekar, Research Analyst at Bonanza Portfolio.

Here are the returns of the broad indices (from Apr 2023 to Sept 11 2023):

Nifty Midcap – 37.38 percent

Nifty Small – 43.27 percent

Nifty Micro250 – 57.69 percent

"While there have been stocks that have rallied more than 100 percent in the same period, creating a fear of missing out (FOMO) in the retail investor community. This FOMO is clearly visible as retail investors have allocated a larger share of their investment pie towards midcap and small-cap categories, which is also evidenced by the jump in the number of folios with AMCs," Kamtekar said.

To create long term wealth, the analyst said, it is important for an investor to invest at a reasonable price and with consistency. At the current juncture, midcap and small cap appear to be trading at premium valuations and therefore, to invest incrementally at these levels would be counterproductive, he noted.

Hence, Kamtekar suggests it would be prudent to stay invested and book profits as "booked profit is better than book profit".

"The fundamentals of the Indian economy are strong and India slated to be the driver for global growth in the long run. From a near term perspective, political risk is the only trigger for a deep correction in the overall markets. Hence, investors should have close eye on the upcoming state elections of Chhattisgarh, Madhya Pradesh, Rajasthan and Telangana before the General Election in 2024," he said.

How to trade these stocks?

"Technically, the trend line hurdle on the weekly chart combined with the gap between the indices level and the short-term average i.e. 20 EMA is also adding to the possibility of profit taking to continue," said Ajit Mishra - SVP, Technical Research at Religare Broking.

"We are eyeing 38,600-39,400 in the Nifty Midcap and 11,800-12,100 zone in the Nifty Smallcap to act as support."

Mishra recommended investors to book partial profits and maintain trailing stop losses in the existing trades. For fresh buying, he said that one should wait for the indices to retrace toward the key support zone and gradually accumulate fundamentally sound counters.

According to Vinod Nair of Geojit Financial Services, the level of pessimism that has risen in the stock market led to a precautionary approach to book profits on a notion that the valuation has extended beyond the rationale.

"The correction is happening on midcaps while large caps are maintaining their strength. This cautious trend can prevail in the short-term, but the end-game is on the rise of the domestic economy, surprising upside in corporate earnings, and change in domestic investment patterns, which is expected to continue on a long-term basis," Nair said.

Dinshaw Irani of Helios Capital India recommended investors to stay away from the midcaps and smallcaps, saying there is still a lot of flavor left. "The smallcap is an ocean. I think that's where the value lies today. Beyond the index, but obviously, the way the money was flowing into these sector specific stocks, in mutual funds, that's why you're seeing this kind of frothiness in index specific stocks as such."

Kotak stops mid, small-cap stock recos

Recently, Kotak has dropped its recommended midcap portfolio as it does not find many stocks beyond the Banking and Financial Services (BFSI) space that offers decent upside potential to their 12-month price targets.

Kotak attributed the sharp price surges to irrational exuberance among investors in these markets, despite deteriorating fundamentals in most companies.

"We see limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap and small-cap stocks. There is no meaningful change in the fundamentals of most companies," the note said, adding that in some cases, it has even worsened.

It attributed the market sentiment to be exuberant based on three factors-

Steep increase in the prices of many mid and smallcap stocks

Large inflows into mid and smallcap mutual funds and

Huge number of new retail participants in the midcap and small cap funds

The brokerage pointed out that there are many stocks that are being termed as turnaround stories. "Many of these companies have been through serious operational and financial challenges in the recent past, but the market has high hopes of these companies doing well in the future."

"We are not sure of the basis of the market's confidence," it noted.

First Published:Sept 12, 2023 5:05 PM IST