The past year and half have been tumultuous for the global market with multiple negative new reports like high gas prices, high inflation, war, bank collapses, interest rate hikes. However, in 2023, the markets appeared to have made a comeback based on positive news.

Markets expect interest rate increases to stop as inflation comes under control, while the bank crises and the war situation do not look as bad as they did a year back. The Indian small cap space has received strong attention from investors due to its strong performance over the last few months.

The Nifty Index is up 18.7 over the past year, while the BSE SmallCap Index is up nearly 28 percentages over the same period.

The strong rally, as usual, has attracted crowds eager to participate in a rising market.

Assets under management (AUM) of small cap funds have increased by 19 per cent since the beginning of the year. Small cap funds recorded continuous increases in small cap fund inflow over the last three months, with Rs 5,472 crore inflows in June 2023.

While there is exuberance regarding small cap funds among retail investors, asset management companies (AMCs), which run mutual funds, having been shutting off new inflows into their funds. These include the Tata Asset Management’s small cap fund and Nippon Small Cap fund have decided to pause lump sum inflows for the moment.

The fund houses have cited liquidity issues as the primary reason for stopping inflows, though systematic investment plans (SIPs) have been allowed to continue. However, some experts believe that high valuations and a cyclical nature of the small cap space could be a reason to slow down inflows into the funds.

The small cap space is illiquid, and accumulation of shares can take months. Funds are forced to buy slowly, so as to not drive up the share price. With cash inflows rising up rapidly, deploying funds would take time – forcing funds to decrease inflows into the fund.

At the same time, valuations have been a cause of concern since the stock prices have gone up rapidly. The limiting of fund inflows has concerned investors since this isn’t the first time AMCs have limited fund inflow into small caps.

In 2017 and 2018, several small cap funds had limited fund inflows while ICICI’s small cap portfolio management service (PMS) even returned money to its investors. Over the next two years, the small cap space entirely collapsed, with the headline index (BSE SmallCap) alone falling more than 30 per cent.

Due to the large size of several of its constituent companies, BSE SmallCap’s decline wouldn’t even capture the larger declines seen in smaller companies. Hence, the last time AMCs limited fund inflows, the market was near its peak. Small caps see much higher activity when liquidity is high, and riskier asset classes are doing better – making them cyclical to a degree.

After dismal performance in 2022, risky assets like crypto, small cap stocks, corporate bonds have seen asset price appreciation in 2023. Liquidity and risk asset performance have a positive correlation. Possibly, the strong performance of risky assets stems from liquidity injections in countries like China, UK, ECB, and Japan over the last few months.

However, the current rally seems to be backed by earnings. So far, earnings appear to be solid, with the non-financial Nifty SmallCap 50 index constituents expected to report a median earnings per share increase of 37 per cent in financial year 2024 (FY24).

With commodity prices cooling off, increased government spending, and strong global cues, the market seems to believe that the companies can achieve these earnings growth targets. However, experts believe that some investors might be discounting these earnings increases in their valuations – which implies that returns could be lower or flat in the near future.

In addition, the markets are valuing these stocks at optimistic levels. With markets discounting earnings optimistically, there always is a risk that a unforeseen negative news or even small deviations from the market’s expected earnings trajectory could cause a rapid decline in prices.

And with the small cap space in India being dominated by retail investors who are more likely to panic in crisis situations, these stocks usually see much higher volatility during panic periods. Retail investors are usually the last segment of the investor community to enter the market, and periods of high retail activity have by periods of consolidation.

For instance, 2017 saw high retail activity followed by a slump, and similar events took place after the bull market of 2021. Currently, the record high inflows from retail investors into small cap mutual funds might be a warning sign of the markets becoming unsustainable.

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