Mid-, small-cap indices rally towards record highs, but analysts warn of overvaluation risks

BSE MidCap index posting gains in 10 out of the last 11 sessions and BSE SmallCap rallying for 11 consecutive sessions.

The BSE MidCap and SmallCap indices have shown significant upward momentum over the past few sessions, with the BSE MidCap index posting gains in 10 out of the last 11 sessions and BSE SmallCap rallying for 11 consecutive sessions.

Since November 13, both indices have risen nearly 9 percent with the BSE MidCap index now just 4 percent away from its record high, while the BSE SmallCap is merely one percent short of its peak. This rally comes after a steep correction from October to mid-November, during which both indices declined by over 10 percent.

More importantly, however, despite the impressive performance, analysts urge caution due to elevated valuations.

Experts caution that it is too early to say if the correction has concluded as they emphasise a shift away from the blanket investment strategy that worked over the past 18 months, advocating instead for a more selective, bottom-up approach. Not every stock in the mid and small-cap segments is expected to deliver substantial gains from current levels, they said.

“I am not overly optimistic that this rebound signals a trend reversal. It’s likely that this rally will face selling pressure due to persistent challenges like a slowing economy, weak earnings, elevated valuations and high inflation,” said Siddarth Bhamre, Head of Research, Asit C Mehta Investment Interrmediates.

“Over the long term -- three to five years -- the structural bull market thesis remains intact. However, in the medium term, we advise investors not to get carried away by this rebound in the mid-cap and small-cap segments,” added Bhamre.

Interestingly, while the Reserve Bank of India has expressed confidence in a recovery for the third and fourth quarters, attributing recent GDP slowdowns to one-off factors like elections and monsoon disruptions, many economists remain unconvinced. High-frequency indicators, such as disappointing auto sales, have raised doubts about sustained economic improvement.

Analysts suggest that the ongoing rally could persist temporarily, but January’s earnings season may bring renewed disappointment.

Gaurav Dua, Senior Vice President and Head of Capital Market Strategy at Sharekhan by BNP Paribas, highlighted that December typically sees strong market performance, often referred to as the “Santa Claus rally.” He attributed the current rally to domestic inflows, given subdued participation from foreign investors during the holiday season. Despite the upbeat sentiment, Dua has advised clients to use this rally as an opportunity to reduce exposure to mid-, small-, and micro-cap stocks, citing a lack of fundamental improvement and continued valuation concerns.

The BSE MidCap index currently trades at a one-year forward price-to-earnings (PE) ratio of 28.77x, which is significantly higher than its 10-year average of 25.93x. Similarly, the BSE SmallCap index is trading at a forward PE ratio of 23.89x, exceeding its 10-year average of 19.64x.

Independent market analyst Ambareesh Baliga echoed similar sentiments, viewing the rally as an intermediate uptrend within a broader correction phase. He said that retail investors’ participation is driving this bounce-back, reflecting their hope for a market recovery. Baliga, however, cautioned against over-optimism, advising investors to stay in cash and partially book profits.

“The macroeconomic data remains weak, and I anticipate further market corrections,” he says.