Sensex-30 Or BSE-500

The stock market exhibits a peculiar characteristic. It takes note of every small negative input and reacts disproportionately to it during a bear phase. When the bulls go on the rampage, it ignores the biggest of the adverse news. The current boom period shows rational expectations and irrational exuberance associated with the latter.

The unanticipated rise of the Sensex and Nifty in recent months implied that the bull run was restricted to a handful of large-cap stocks of renowned companies. Some of you were fortunate enough to benefit from this rally, but many missed the profitable bus. Today, these large-caps are too expensive, and beyond the reach of small investors.

But wait, don’t be disheartened. In the last three months, the indices for small-caps and mid-caps outperformed the ones for the large-caps. The Nifty Mid-Cap 50 and Nifty Small-Cap 50 have recovered to pre-COVID levels but, unlike the Sensex, they haven’t touched their respective all-time highs.

Having added over 1,000 points every month since May this year, the BSE Small-Cap and Mid-Cap indices had zoomed 95 per cent and 77 per cent, respectively, by November 27. These, however, were below their all-time highs of above 20,000 points and more than 18,000 points, respectively.

Is this the beginning of better times? Should you look at the smaller stocks more carefully? Let us add the usual warnings. Both small-cap and mid-cap shares are risky, and such companies are not as stable and resilient as the frontline large-caps. Besides, the COVID scare and fear are likely to impact the smaller firms more than their larger counterparts. Chances of wrong stock picks and ill-timed buys are very high. To add to your worries, experts predict a correction in the market, even as they feel that the boom will continue.

Nischal Maheshwari, Chief Executive Officer, Centrum Broking, thinks that the small-caps and mid-caps may outperform the broader market in the medium term. “The current volatility provides a good entry point for accumulating these stocks which are likely to outperform in 2021. However, the performance remains contingent upon the sustainability of economic recovery amidst COVID-19 uncertainty,” he explains.

Gaurav Garg, Head of Fundamental Research at CapitaLvia Global Research, finds these non-broader indices promising. “They have the potential to, at least, test their all-time highs,” he says. But other broader indices, such as the Nifty 500 and BSE 500, are in congruence with the benchmark indices.

One of the reasons for this optimism lies in global liquidity — the availability of money, which is likely to be funnelled into stocks in emerging markets. Foreign Portfolio Investors (FPIs) channelled their colossal pool of resources in Indian frontline stocks. Sensex skyrocketed. Earlier, in March-April 2020, FPIs squeezed out a massive Rs 69,000 crore. Since then, their net buying, as on November 27, stood at a whopping Rs 1,63,160 crore. In November, they pumped in Rs 60,000 crore. Post COVID-19, several central banks across the globe declared stimulus packages to get their economies back on the fast track. This liquidity found its way into stocks and bullion. “Not only equity, precious metals like silver and gold, gave decent returns in the recent past,” says Nimish Shah, Chief Investment Officer (Listed Investments), Waterfield Advisors. “It is following the global economic situation and a weakening dollar.”

As interest rates crashed in most nations and moved into the negative territory in many countries, global money invested in safe securities and bonds moved out to seek higher returns. “Finally, the money will go where the returns are high. On the fixed-income side, yields are diminishing. This money will naturally flow towards other assets, where yields are higher and consistent,” agrees Shah.

However, liquidity is a double-edged sword. Its biggest advantage is that it pushes the rally deeper, and transforms it into a broad-based one. For example, until now, this excess money chased the better stocks, generally large-caps. Once their valuations go up tremendously and reflect expected earnings several quarters ahead, the focus has to shift to mid-caps and small-caps. Fortunately, this has begun to happen in the Indian stock market.

Maheshwari says, “Markets have exhibited polarised behaviour in the last few weeks. However, we expect broad-based action to be back once investors are assured that there is sustainability in the economic recovery. Mid-caps and small-caps still have a long way to go, especially on multi-year time frames. We expect the uptrend to continue next year.”

But the liquidity game can become a losing one too. Garg says, “Everything in excess is opposed to nature. Liquidity beyond a certain level has its challenges. There is a sudden wave of liquidity in the markets when there is access to cheap money. When money is available at lower costs, markets become a lucrative opportunity to invest, and such a sudden influx of funds tends to mislead valuations”. The current scenario exhibits this pattern. Gita Gopinath, Chief Economist, IMF, described it as a “Liquidity Trap”, and expressed concerns over a potential rise in global inflation, which can turn off the tap.

If, and when, the central banks and governments decide to restrain the money supply, liquidity dries up instantly and leads to a correction. The adjustment becomes prolonged if the FPIs simultaneously decide that stock valuations are distorted. They close their positions, and stocks slide back to their intrinsic values which, in many cases, may imply huge downturns.

Garg explains, “Older investors, or those who entered early, may benefit from this situation. But the newer investors may not gain (unless they are in for short-term profits).” In such cases, it is more advisable to wait for the dust to settle down, and liquidity to play out its role, before one enters the market. As Garg adds, it is better to go by fundamentals, macro trends, and stock-specific trends.

Every investor, in these trying times, needs to be aware of other global developments. In North America and Europe, the spread of the second wave of COVID-19 has been swifter than the first one. Its impact on these economies will be felt by December. It may hold the potential to destabilise the global economy, and yet end up as a positive for the Indian stock market. Money is likely to stay invested in emerging markets with bouts of fresh inflows.

A few signs are already visible. US stock indices have shot up over the past eight months, faster than the European ones. Fresh lockdowns in several European countries dampened investors’ enthusiasm about their markets. Sensex is the best-performer when compared to the foreign ones. Only Nasdaq, which comprises tech stocks, has outperformed the Indian index as technology firms are the biggest beneficiaries of COVID.

The launches of COVID vaccines will instantly change the equation. As developed nations are likely to get them first, their economies will recover faster. It may nudge foreign investors to seek safety, reduce risks, and re-invest in these markets. However, the money will continue to flow into emerging markets if India and China manage to witness higher growth rates, as was the case in the pre-Covid times. It will inflate valuations further. Therefore, developments in India, China, the US, and the rest of Europe will prove to be crucial over the next few months. China’s growth is back and was just under 5 per cent. The new American President, Joe Biden, may ease trade and immigration restrictions imposed by the previous regime. But his policies to hike tax rates, and spend billions in green technology may not go well with investors. India’s macro indicators seem to be a mixed bag (see accompanying piece). While there are green shoots of growth, there are issues with the broad macro trends.

However, experts are convinced that the Indian market has seen its bottom in late-March this year. We are unlikely to see those levels in the near future. Yet, small investors need to be prepared for regular small-time shocks, or corrections. A sustained bull run will go hand-in-hand, as it usually does, with minor downturns. They can frighten the investors, or they can signal new entry points for fresh investments.

“The volatility is inherent to the market. The movements in stocks are never unidirectional. You will encounter known and unknown risks if you invest in equities. At this time valuations, which are higher than their long term average, can also pose a risk along with any possible risk events,” explains Harsha Upadhyaya, President (Equity), Kotak Mahindra Asset Management.

What is important for the retail investors is the near-consensus that foreign investors are unlikely to panic in a hurry.  In March and April 2020 they sucked out funds from India and other emerging markets. What is also true is that governments, central banks, and institutional investors have learnt to live with COVID. Any developments on this front is unlikely to overpower the markets. Garg is confident that the Nifty is unlikely to fall below 10,400.

In fact, an optimistic Maheshwari feels that if everything works to expectations, “normalcy will return by March 2021. He, therefore, thinks that it is time to add “beta” to one’s portfolio. In essence, investors can look at stocks, which are likely to respond better than the overall market. This means that investors will be exposed to lower risks as we move into the next year.

Of course, we want higher returns. This year was terrible for many of us who lost their jobs, went through salary cuts, and saw their portfolios crash and then recover a bit. More importantly, most of us were not prepared for the bounce-back of the stock indices. If you wish to take risks, and you have money to spare, seek ‘alpha’ (excess), not beta, returns.

The search for alpha means that you need to get out of the large-cap comfort zone. Go ahead, and invest in mid-caps and small-caps. But be extremely careful. Experts contend that even if the rally extends to the smaller stocks, it will not be entirely secular. Only a few of them will witness higher valuations. In fact, many of them may be wrecked by COVID related disruptions. So, choose well. All the best, and may the New Year ring in higher returns.

yagnesh@outlookindia.com