By Bharath Rajeswaran

BENGALURU (Reuters) – A roaring rally in mid- and small-cap stocks listed on Indian bourses could see abrupt corrections, as many of them trade at near or record highs even though overall consumption demand remains sluggish, at least six analysts said.

The Nifty mid-cap 100 index has hit fresh all-time highs in each of the previous seven sessions, gaining 19% so far in fiscal year 2024, while the small-cap index touched new 52-week highs over the last seven sessions and added 20% year to date.

In contrast, the benchmark BSE Sensex and the NSE Nifty have gained 7.7% and 8.6% in the same period, respectively.

“The sharp rally in mid and small caps seem to be bordering on euphoria as consumption demand remains sluggish and valuations have reached unrealistic levels in most cases,” analysts at Kotak Institutional Equities wrote on Monday.

Growth in the Indian economy is seen slowing to 6.5% in the current financial year compared to 7.2% last year. In the Jan-March quarter – the latest data available – private consumption grew just 2.8% even as government spending boosted the broader economy. Weaker demand could weigh on company earnings.

Others warned of erratic monsoons, which can impact India’s largely agriculture-based economy.

“Nothing is cheap right now, so investors have to be very, very selective on midcaps,” said Avinash Gorakshakar, head – research at Profitmart Securities. “If monsoon is not as per expectations, we could witness a temporary halt in the rally.”

The 12-month forward price-to-earnings ratio – a metric that measures valuation of an index or security – of the mid-cap index stood at 24.1 on June 20, while the Nifty 50’s P/E ratio was 21.9. The P/E ratio for the small-cap index was just below at 19.6.

The P/E ratio of midcap index has risen from 23.5 at the start of the year to 24.02 in June while the P/E ratio of smallcap index rose from 16.39 in January to 19.6, amid the rally in markets.

Most mid-cap stocks are also trading well above their pre-Covid multiples.

DOMESTIC DEMAND

A strong inflow of funds from domestic investors has been instrumental in pushing up valuations.

Since January 2022, mid-cap equity-oriented schemes and small-cap schemes saw inflows of 286 billion rupees ($3.49 billion) and 318.91 billion rupees respectively, twice as much as the 143.45 billion rupees invested into large-cap schemes, data from the Association for Mutual Funds in India showed.

The interest in this set of stocks has prompted fund house Motilal Oswal to launch India’s first-ever micro-cap index fund for investors looking beyond the Nifty 500 firms for hidden opportunities.

“Large caps can absorb that much of liquidity, but when midcaps start attracting that kind of flow, then it becomes difficult to absorb liquidity and valuations will get re-rated,” said Hemant Kanawala, head – equity investments, Kotak Life Insurance.

One 97 Communications, Aurobindo Pharma, PB Fintech have been among the top mid-cap performers in 2023, adding over 40%.

To be sure, not everyone is skeptical about the recent rally.

“Post the correction in global equities in 2022, the rally in Indian markets has been more broad-based and has trickled down to midcaps,” said Atul Suri, chief executive officer at Marathon Trends Advisory.

Suri expects the rally in broader markets to continue, led by the revival in the industrial cycle. He identified inflation as the major lingering risk to the Indian market rally.

($1 = 81.9878 Indian rupees)

(Reporting by Bharath Rajeswaran in Bengaluru; Editing by Dhanya Skariachan and Nivedita Bhattacharjee)

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