The Divergence : The Confusion
The Nifty has reclaimed its highs in recent weeks even as the Mid and Smallcap indices have selectively bottomed out or so it looks. So far and as of now, the Midcap Index is down 13.5%/Smallcaps down 21% – while Nifty is up 4.5%.
This is for us natives of course – if you were a foreigner invested in USD, you are down almost 30% on smallcaps since January 18 as the INR itself is down 8% or so!
There have been several reasons for triggering this initial fall in headline indices (Read https://www.plindia.com/blog/the-midcap-mayhem-is-it-close-to-ending/) and PL had been warning of a correction right since January 2018 (https://www.plindia.com/blog/pl-warning-on-correction-in-the-markets-feb-2018/).
This divergent move has therefore triggered a massive wave of investor queries as portfolios go one way while the Nifty goes another way completely – most portfolios we presume are still down between 10% – 25% (without leverage) and the ones with leverage must have been impacted much more right since January 2018 when the corrective stages started.
So what does history suggest and how long does it take for portfolios to again start making sense?
Recent History of Index Divergences
Technical analysts often study the divergence between the smallest components of markets (like the Russel 2000 vs Dow in the US or versus BSE Midcap vs Nifty in India and so on) and the typical historical behavior suggests the following:
1) When Nifty makes lower tops or lacking life while BSE Smallcap Indices continue to make higher highs : This kind of a situation typically portends a 10-25% downmove on smallcaps and 5-15% on the benchmarks. This is what has happened since January 2018 and such sharp falls have been seen earlier as well .
This has happened several times earlier as well and the deepest of these have been in
- Last few months of 2007 where Nifty was making lows while the Midcaps were making new highs and then it followed with a massive correction
- A similar situation emerged in late 2015 – which again followed up with a sharp correction starting January 2016
- The third of these was immediately prior to demonetization where the Nifty was stuck in a range and the Modi announcement broke the back!
2) When Nifty/Sensex does not break new lows or makes new highs but the BSE Smallcap Index makes new lows with sharp downmoves : In this situation we generally see a major bottom being formed and a 10%-25% jump in smallcaps. This is the time to start looking for momentum reversals.
- This move was seen in early 2009 when the Midcap indices kept crumblng even as Nifty was flattening out and soon followed with a rally.
- Again a similar situation followed in 2013 once the INR broke Rs 70 and there was panic – but once the divergence became sharp, it soon followed up with a sharp upmove
While this blog cannot make any market predictions, history does suggest that we might be in the middle of the start of a corrective rally in midcaps which may continue for some time even if the Nifty flattens out at current levels or indeed slightly lower.
Other indicators like volumes (Current Nifty Stock volumes at 54% of total market volume is at an extreme and during crazy rallies accounts for between 30%-35% – it is therefore likely that volumes may also return to Mid and Smallcaps as it is often a reversal indicator) also indicate that a rational reversal is under way and may continue to remain in place for some time. If you start seeing newer 52 week highs on Nifty stocks, you may be sure a sharper upmove in smaller ones is well on its way!
In summary therefore, it may be time to hold on to your small and midcaps as you have already suffered the pain and possibly keep stops near their lows that you saw in recent weeks. Let the portfolios regain health slowly as the divergence disappears and fundamentals take over.
Being a year where we are headed into elections, and a large amount of volatility abroad, it is likely that there may be sharp whipsaws and the sure sign of an exit in the markets would be if an when Nifty corrects sharply – till then , mount your horses and charge!
And don’t blame your advisor for performance against the Nifty – if he has recommended good quality stocks but just prices are down (while fundamentals remain strong), let him be! He needs to get back to his drawing board to help you create good portfolios!
Write in to us at firstname.lastname@example.org if you need any advice or suggestions on your portfolios today!
PS: Buffett’s famous line (2008 ): “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”