Mid, smallcaps show signs of weariness. Are they ripe for a healthy correction?

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In sync with the benchmark Sensex and Nifty, the BSE midcap and smallcap indices also hit their all-time high in morning trade on August 4.

The Sensex and the Nifty hit fresh record highs of 54,440.8 and 16,290.20, respectively, while the BSE midcap and smallcap indices scaled fresh peaks of 23,478.8 and 27,323.18 in intraday trade.

However, the mid and smallcap indices cooled off after hitting record highs and fell about half a percent each due to profit-booking even as the benchmarks remained up with gains of about a percent.

Mid and smallcaps have outperformed the frontline stocks this year so far by a huge margin.

As of August 3, the Sensex has gained nearly 13 percent in 2021, while the BSE midcap and smallcap indices jumped 30 percent and 50 percent, respectively.

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Correction in the offing?

The ongoing rally has seen many stocks jumping to record highs. However, their fundamentals do not look to be in sync with the gains in their equities. In case of a correction in the market, such stocks suffer significantly.

"A bull market brings with itself the kind of hysteria which hugely benefits small and midcap companies," Nirali Shah, Head of Equity Research, Samco Securities, pointed out.

At present, the valuations of mid and smallcaps are rich and reflect signs of caution.

"The Nifty smallcap index is trading at a premium to Nifty, and valuations of the Nifty midcap index are at par with Nifty. This should set alarm bells ringing for participants majorly invested in small and midcap companies. With any sign of panic, the broader markets will be the first to crack," Shah said.

Also read: Nifty's journey to 17,000 could be bumpy, but bull run could lift it to 18,000 by December: Experts

Mehul Kothari, AVP, Technical Research, Anand Rathi, pointed out that the Nifty500 is hovering near the long-term trend line resistance and 200 percent retracement level of the previous crack.

"Ideally, the broader markets are hinting towards some exhaustion. The rally from here in the midcap and smallcap stocks might not be one-way, like it did in the past couple of months. For the short term, one needs to stay cautious in them," said Kothari.

Also read: With Nifty at 16,000, realty and textile sectors are worth a look, says Abhishek Chinchalkar of FYERS

What should you do?

Quality stocks from the midcap and smallcap space may continue to see gains as the market sentiment is upbeat amid signs of improvement in the economy. The surge in the number of retail investors is also supporting the rise in the market.

"The mid and smallcap segments are more performance-based. Companies that are delivering results are being bought into even during volatile sessions. The midcap tech companies and fine chemicals are examples. We remain confident and hold on to these midcap stocks," said Anu Jain, Head, Equity Broking, IIFL Wealth.

Some pockets of the mid and smallcaps may see correction but sectors like commodity, sugar and metals still look promising and one may add stocks from these sectors in case a correction occurs.

The broader markets underperformed for a long four-year period -- from 2017 to late 2020. Attractive valuations, along with improved earnings (post-pandemic), led to a decent momentum in this space, Ashis Biswas, Head of Product, CapitalVia Global Research, said.

"Their outperformance may continue in FY22, especially from sugar, metal and commodity stocks. Investors should add quality midcap growth stocks to their portfolio during corrections," said Biswas.

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