Why the Stock Market is Falling

The Indian stock market has taken a pause over the last week. Just a couple of weeks ago, the benchmark indices were scaling new life highs. The bull market seemed unstoppable.

But the market sentiment has changed. The Indian investor has been hit by a few rude shocks recently.

The big question on the minds of investors now is the continuation of the bull market? When will it resume? Or will the impact of recent events be serious enough to bring an end to the momentum.

Let's find out...

#1 The Regulator's Concern About Valuations in the Broader Market

Despite the run up in the market in 2023 and the start of 2024, large-caps stocks are still not insanely priced. They're not cheap but not too expensive either.

At the time of writing, the Nifty's PE ratio, a decent measure of the overall valuations of the market, is just under 23. A PE of 25 is considered expensive as far as the Nifty is concerned.

However, the situation is quite different in the broader market. Midcaps and smallcaps have soared to highs most investors did not dream of.

In 2023, it became common for even half-decent midcaps can smallcaps to become multibaggers. We have written about some of them, for example the stock of PFC or the stock of BSE.

The BSE Smallcap index peaked at 46,821 in early February. It's down about 10% since then.

While the fundamentals of companies in the smallcap space have recovered, it was liquidity and valuation expansion driving the gains.

This was evident from the rise in Smallcap to Sensex ratio. At the start of 2023, the Smallcap to Sensex ratio was at 0.46 times, as compared to a long-term median of 0.43 times.

In February 2024, the ratio was way past that average. At 0.63 times, the Smallcap to Sensex ratio had breached the previous peak of 0.58 in 2018.

The earlier corrections from the peak have been in the range of 50-70%. The recovery from the last crash in smallcaps took 3 years. This pales in comparison to 9 years post 2008 crash.

As such, caution and not greed would have been the right sentiment to approach smallcaps. But retail investors kept pumping money into the market, especially into smallcaps.

This is why the regulator stepped in and expressed concerns about not only the valuations but also the rampant speculation.

#2 Mutual Fund Stress Tests

Following this, mutual funds conducted stress tests on their smallcap and midcap schemes.

The idea was to find out how much time it would take for a smallcaps scheme to liquidate 25% and 50% of its portfolio.

This was done to find out the potential impact of the worst-case scenario of redemption pressure in the case of these funds.

Well, the initial tests have been completed and the results are in.

The average number of days to liquidate 50% of small-cap funds' portfolios is 14. The average number of days to liquidate 50% of mid-cap funds' portfolios is 6 days. There is also a vast difference between funds in terms of liquidity.

Mutual funds will have to disclose this data every 15 days. Mutual fund investors will need to take these numbers into consideration before taking any action.

#3 Electoral Bonds

The noise surrounding the buyers of electoral bonds has caused concern in the market.

The case is in the Supreme Court. We could see hard data on the companies that donated to specific political parties as well as the amounts by the end of this week.

If this issue could potentially cause problems for the market, then next week is the time when the impact will be felt.

For now, it's a secondary reason for the volatility in the market.

Conclusion

We can understand why this would be concerning to many investors today, especially those with a big exposure to midcaps and smallcaps in their portfolios.

There is genuine concern among investors that the market has run up too much and if the Nifty were to keep rising to say 25,000, then their investments would be at risk.

But does that mean the Nifty will fall if it were to rise to 25,000?

No.

We at Equitymaster have seen all kinds of market moves for more than 25 years. We know something important about bull markets. They peak only when the market's sentiment changes from positive to negative. If this doesn't happen, then the correction will be temporary.

We've seen this play out since the year 2016. Every correction in the Nifty that looked serious initially, turned out to be a dud. Even the losses of the covid crash were reversed in a few months.

This is because of the massive commitment of the Indian retail investor. If they keep pumping in a few billion every month (in dollar terms) via mutual funds, direct investments, etc, the market won't fall too much.

So, it would seem the answer to the question is simple. The bull market will end when retail investors significantly reduce their participation.

And this will only happen if there is a drastic change in market sentiment from positive to negative.

So far that hasn't happened.

Happy investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...