Events are flowing thick and fast. Let us look at macros first.
A falling rupee. Rising oil. Spiking prospects of food prices. Rising inflation. Looming trade battles.
The setting reset has already started reflecting in stock prices.
A sharp cut in midcap stocks and indices reflects a clear reversal of investor optimism. This reversal is still fluid and nowhere near pessimism. There is a tentativeness in the air. Fence sitters stand watch, looking for sentiment to improve in midcaps. Contrarian buyers are thinning. Fewer people think that this situation will reverse soon. But, not too many think it will get much worse. The majority think valuations will stay this way. That prediction stands delicately on thin ice.
The construction of benchmarks, the portfolio orientation to benchmarks, alignment of domestic flows to specific parts of the markets, and the risk aversion of professional managers are all likely to work against the dominant investing styles that worked in 2017-18.
Governance is sharply in focus right now. Auditors are resigning rather than signing books they are not comfortable validating. This trend is likely to gain further momentum. Evidently, more midcap, small caps, and microcaps are likely to be affected by this trend.
Meanwhile, the index seems to be stronger than the rest of the market. It is ironic that investors have failed to capture the emerging strength within even the index. Large cap funds are struggling against the very index they choose their stocks from. Thus, it seems like a nightmare to even beat the benchmarks.
Investment performance in times like this is going to be choppy.
All the while I talked about the returns beating benchmarks. Now, let us discuss the prospect of negative returns. This is a very uncomfortable thing to talk about. But, investing will grow and succeed only if we can face our mistakes with honesty. This concerns smaller companies, their valuations, and the downside that seems probable.
We saw small, mid, and micro caps beating the benchmark by miles. The outperformance was so strong that it almost became a de facto strategy for many investors to focus only on them. This approach has not played out well. The midcap and small cap indices have taken a beating in the past few months. We see further downside in these segments.
With sentiment seeing churn and with index showing a clear rebound, a rethink is now inevitable. As losses mount in the smaller companies, the flight to safety is going to be crowded with scarred and scared investors. Those who got in towards the end of the bull run are going to run out of this space. This could lead to much pain.
Staying away from midcaps has been a good strategy. It has worked very well for those who chose the difficult path. Losses have been avoided. Profits booked have been protected. Getting into them should be gradual, rehearsed and well thought through. There is no rush to take more risks in one’s portfolio. Clearly, one’s risk mosaic is needing a quick reset if it hasn’t gotten one yet.