Well, there is a saying that goes, "Enjoy the party while it lasts, but it may not be a bad idea to catch your breath or sit near the exit in case the music stops." We hope the party for the broader markets continues, but there are a few significant indicators that suggest some reasons to be a little cautious.

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The current state of the markets often sparks discussions on whether consolidation would be beneficial for the overall market health. By examining key factors such as valuations, earnings yields and market capitalisation, we can assess whether some consolidation in broader markets would be considered healthy at this juncture.

1. Investor sentiment moving into extreme bullish zone

Earlier this week, CLSA sentiment indicated that we could be entering an extreme bullish zone.

Image: CSLA

2. Valuations: A little higher!

The valuations in the midcap segment of the Nifty index have been slightly higher than the 10-year average. This indicates that there might be some concerns about overvaluation within this segment. A period of consolidation could help address these concerns and bring valuations back in line with historical averages.

3. Earning yield focus

The yield spread measures the difference in earning yields between different categories.

As the above chart indicates, earnings yield is higher in the mid, small and micro caps. However, we need to note that their earnings could be at a higher risk when the domestic and global environment deteriorates. In general, smaller companies have displayed higher earning yields compared to large caps, but when the prices move up, the yields cool off.

Focusing on the yield spread to large cap in the case of midcaps, the current yield spread is 50 basis points, slightly lower than the 10-year average of 60 basis points. Similarly, small-cap and micro-cap stocks exhibit yield spreads of 30 basis points and 150 basis points, respectively, lower than their respective 10-year averages. A phase of consolidation could help compress these yield spreads, making investments in these segments more attractive and fostering a more balanced market.

4. Mid and small cap contribution to total market capitalisation

The contribution of mid and small-cap stocks to the total market capitalisation has witnessed a modest increase over the years. If we look at data for the past 15 years, market distribution suggests mid-small cap stocks are moving towards historic extremes, which could be a reason for concern.

Based on the analysis of valuations, earning yields and market capitalisation, some consolidation in broader markets can indeed be considered healthy. It addresses potential overvaluation concerns, provides opportunities for higher-yielding investments, compresses yield spreads, and promotes a more balanced market ecosystem.

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However, it's essential to approach consolidation with a comprehensive understanding of the specific market conditions and factors influencing its outcomes. By striking a balance between stability and growth, consolidation can pave the way for a healthier and more sustainable market environment.

(Edited by : Ayushi Agarwal)

First Published:Jul 14, 2023 6:55 PM IST