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Unraveling the Recent Small and Mid-cap Market Fall : Learning from the Past, Charting the Future

Updated: Apr 12, 2024

In 2005, Small cap and Midcap companies made up 17% of the stock market and in 2023 it stood at 36%, the pie has more than doubled! And if you see the returns produced by small cap in the past couple of years you'd be stunned: 2021 ~ 100%, 2022 - 37% and in 2023 - 40%.

While these small caps stocks have rallied up, the valuations have caught on too, the Nifty Small cap 250 PE is at 28.0, an all time high and PB is at 3.8, also an all-time high.



Now, there's been a lot of talk in the stock market about a big sell-off happening in smaller and mid-sized company stocks. This has caught the attention of many investors who are wondering why it's happening. Let's take a closer look at what's going on and how it fits into the larger story of India's economy.


Why the recent downturn in midcap and small cap funds?


The recent downturn in midcap and small cap funds can be attributed to several factors:


  1. Valuation Concerns: Elevated valuations in the small and midcap segments have raised concerns among investors and analysts. The prices of these stocks reached levels that were seen as unsustainable, prompting a correction.

  2. SEBI's Statements: SEBI expressed concerns over the buildup of frothiness in the small and midcap segments, signalling regulatory scrutiny and potentially dampening investor sentiment. It underscores the necessity for prudent navigation in the stock market's turbulent waters. The regulator's primary goal is to ensure a stable and transparent market environment, safeguarding investors from potential losses that accompany inflated valuations.

  3. Stress Test: Stress test aims at analyzing scenarios where mutual funds' liquidity will be tested, it has shone put the spotlight on lofty valuations in the small cap segment. Growing scrutiny and concerns over rising liquidity within the small cap space has prompted investors to take a step back and book partial profits, resulting in a meltdown. This stress test will help understand about how much time will the small and mid-cap funds take to liquidate 25% or 50% of the portfolio if there is redemption pressure.

  4. AMFI and SEBI Directives: The Association of Mutual Funds in India (AMFI), following directives from the Securities and Exchange Board of India (SEBI), instructed mutual fund houses to halt further investments in small and midcap indices. This move was aimed at addressing concerns over excessive valuations and potential risks in these segments. Investors should recognize that corrections are a normal part of market cycles and remain vigilant about risks associated with investing in small and midcap funds.

  5. Shift to Large Cap Stocks: Large-cap stocks started to appear more attractive to investors due to relatively cheaper valuations compared to small and midcap stocks. Consequently, funds might have reallocated their investments from small and midcap funds to large-cap funds, putting downward pressure on the former.

  6. Promoters Selling Stakes: Promoters taking advantage of the market boom have been selling their shares, adding selling pressure to small and midcap stocks and indices.


What should I as an investor do?


For individual investors, the warning is a clarion call for due diligence. The allure of quick gains from soaring stock prices can be enticing, but the fundamentals should not be ignored. Investors are advised to reassess their portfolios, focusing on the financial health of companies rather than merely chasing high returns. Portfolio Diversification, Continuous portfolio review and a keen eye on long-term financial goals remain paramount in navigating market uncertainties.


  • If you are a Long-term Investors: Hold onto investments if aligned with long-term goals but reassess allocations. However, for long-term investors with a healthy appetite for risk, a strategic buying approach during downturns can pay off.

  • If you are a Near-term Investors: Evaluate whether the planned exit from these funds is imminent. If so, consider selling and reallocating to safer asset classes.

  • If you are a SIP Investors: Continue systematic investment plans (SIPs) for mid- to long-term goals. Consider lumpsum investments during significant corrections, but only if prepared to hold for an extended period.


  • If you are a new investor or existing long-term investor: Consider allocation in pure large cap funds, Invest across market caps with major allocation to pure large cap or large cap index funds and Flexi cap funds with large cap bias. Within large cap, diversify it further between growth and value strategy. Any fresh allocation, Limit allocation to mid and small cap funds at 15-20% of portfolio. Adopt a staggered approach for any new allocations or investments over the next 3-6 months.


In conclusion, while corrections in small and midcap segments are healthy, investors should remain cautious and informed, considering their risk tolerance and investment objectives. Regulators are actively monitoring the situation to safeguard investor interests.


Looking Ahead: A Balanced Approach


In 2024 we're sitting at a point of inflection. Inflation is controlled, high probability of BJP coming back, a fall in repo rates and a rising middle class. It's a golden opportunity for equity investors but small caps have probably had their run and in the next 12 to 18 months we might see muted returns. In 2024, large-cap stocks might make a significant comeback.


As the Indian stock market continues to evolve, the regulator's warning on small and mid-cap stock valuations is a timely reminder of the inherent risks in stock market investments. It underscores the importance of a balanced approach, combining thorough research, prudent diversification, and a long-term perspective. While the pursuit of growth is a natural investment goal, navigating the stock market's complexities with caution and informed judgment is essential for enduring success. This highlights the need for vigilance, informed decision-making, and a balanced investment strategy in the face of market volatility. As the financial landscape continues to shift, embracing a disciplined approach to investing will be key to navigating future challenges and capitalizing on opportunities in the Indian stock market.



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