Don’t wait for election cycle to end before investing into smallcap stocks

Updated: December 4, 2018 3:29 PM

Is there a way to put the ongoing smallcap correction in a context that can cut out the noise and give us a unique perspective that can help investors to make an informed decision?

Overall, smallcaps is not an easy space to be in, as one experiences gut-wrenching volatility every now and then.

By- ArunaGiri N, Founder CEO & Fund Manager, TrustLine Holdings

When the going is good, small cap space does wonders. It is one of the most lucrative spaces with attractive returns, in such times. It turns unfavourable when sentiments sour. Overall, it is not an easy space to be in, as one experiences gut-wrenching volatility every now and then. But the space provides rich long-term rewards, if one has the right temperament to stay put with the right stocks. However, when they nosedive and undershoot, like in the current times, we find no dearth of experts writing its obituary, with some even going on to say not to touch the space till elections cycle gets over. This is a misguided view and is based on misunderstanding about the ongoing correction.

Is there a way to put this correction in a context that can cut out the noise and give us a unique perspective that can help investors to make an informed decision? A simple plotting of small cap index for last 15 years along-with the level of dollar index at critical points shows the following:

 

  1. Every time when the dollar index rallied, there was a big crash in small cap index, be it 2008, 2011, 2013 or now in 2018. All big fall in small cap index has been accompanied by spike in dollar index.
  2. More importantly, every time when small-cap index fell by a certain level, the subsequent bounce in the next immediate year has been stronger (by 1.5 times) irrespective of the narrative at that point in time. This is not a one year wonder, but a consistent repeating theme year after year for 15 years, without any exception. Going by  this, given the fall of small cap index by over 25% this year, it is no brainer that the index will bounce by at-least 40%+ in the coming year.

Why are people then not jumping in to invest?

When this question is put across to investors, the response is weird. Investors give more weightage to the impending election cycle than to the data thrown by the chart. This clearly misses the point. To put this correction in perspective, it is not India specific. It has nothing to do with domestic issues, though some domestic challenges like ILFS have aggravated the crack. It is more to do the cycle of dollar strengthening and Fed tightening.

As in the past, every time when dollar index made a strong rally, emerging markets like Asia (ex-Japan), Brazil, Russia etc. took a huge knock in their stocks, currencies and in their yields when money moves out of emerging markets. India is no exception to this. This is because of huge unwinding of EM carry trade on dollar strengthening. This explains why there is such a strong correlation in the chart between the small cap index and dollar index.

As with the past cycles, this is not a one-way traffic. EM carry trade does resume after a while. One can’t predict when this turns, but going by earlier cycles, it is reasonable to assume that it can’t take longer than 10 to 12 months, as even in the worst financial crisis of 2008, it didn’t take more than 14 months. When the trade resumes, money starts coming into EMs. At that time again, it is not going to be India specific. When FIIs come back, they are going to allocate across EMs as a basket, based on some benchmarks like MSCI etc. India is unlikely to get left out just because of election risks. What will trigger the resumption of carry trade is a million dollar question. We don’t know. It could be simply because of overselling or EM equities becoming more attractive in valuation because of beaten down currencies etc.

There are two critical observations here-

  • When carry trade resumes, markets may see a strong bounce irrespective of election risks as it happened in the past cycles, and
  • Election risks unlikely to play a major except for increased volatility closer to the election. The best way to deal with such risks, is to be stock specific and bottom up and keep buying whenever one gets the target price.

Already one can see the early signs. FII flows have turned net positive in the month of November after very long time. Ten year yield has come off from the high of 8.15% to 7.75 odd. Rupee has come off from the low of 74 and the next in line could be dollar index. When it cracks, it will be EM times again. Watch out for interesting times.

Get live Stock Prices from BSE and NSE and latest NAV, portfolio of Mutual Funds, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.

Switch to Hindi Edition