5 reasons why Elara Capital thinks markets may see prolonged weakness

Analysts at Elara Capital analysed market breadth cycles in India stock markets in the last few years and highlighted the worrying points that are developing for the first time in five years.

The Indian stock market, especially the mid-and smallcaps, could remain in a prolonged phase of weakness.  Analysts at Elara Capital analysed market breadth cycles in India in the last few years and highlighted the worrying points that are developing for the first time in five years (post COVID) in the Indian equities.  Here are the 5 key takeaways from Elara Capital's research note:  Market breadth models breaking down from 'Euphoric Zone' after 5 years  Elara Capital note highlights that their flagship indicator captures the relative performance of Equal Weighted, with a weighted portfolio of NSE 500 stocks hitting a significant peak from where cracks have started building up.  The curve measures phases CLICK FOR CHART of market when correction, number of stocks witnessed expansion in Index weight v/s contraction (NSE500 stocks). To simplify, at the lowest point in May 2020, the Nifty 500 index moved by a handful of index heavyweights, while the rest of the market underperformed. However, in the period post that, as the broader market started to move up, the weight contribution towards the index improved.  The curve, according to Elara Capital, has again reached the euphoric zone from where we are seeing signs of reversal and resumption of polarization like we saw in 2006-2009, 2011-2013 & 2018-2020 period. The absolute correction in mid-and small-cap stocks was very sharp in 2010-2013 & 2018-2020 period. However, in the 2006-2007 period, markets gave absolute returns but on stronger rally in large-caps compared to mid-and small-caps.    This market breadth model suggests the need to aggressively shift positioning to large caps.  Where to invest?  Historic trend shows that any reversal in breadth has been very good for outperformance of the Consumption sector as a whole (largely due to liquidity moving back into quality). It also recommends investments in heavyweights within the IT, Bank, Pharma & Consumption space as against Mid- and Small-cap stocks.  Beta Trade reversing after 5-years - confirms waning risk appetite  Traditionally, Beta has been a good indicator for gauging the risk appetite of the market. Importantly, any weakness in markets after the crowd has entered a Beta trade has been associated with high risk of unwind. REFER CHART  In the current cycle, High Beta portfolio already peaked in outperformance versus Low Beta in June 2024. From there relative returns have started shifting in favour of a Low Beta/ Defensive positioning. Such shifts were seen in December 2005, July 2008, April 2010, January 2015 and April 2018 periods. Except for December 2005 (when markets continued to rally but led by defensive names), in all other cases we saw absolute price correction in markets and largely in SMID space. Defensive strategy outperformed in those periods.    That apart, during the panic of 2020, more than 80 per cent of the cash market volume was concentrated in top-100 stocks. In the rally that followed, this volume dropped to 50 per cent signifying a big shift of activity into Mid- and Small-cap stocks.  Volume of top-10 stocks dropped from 31 per cent in 2020 to 15 per cent now. Finally, we are seeing early signs of volume profile shifting back towards larger stocks. This would mean liquidity issues in smaller names creating a bigger price damage even on small supply.  The Mutual Fund conundrum  Mutual Funds (MFs) continue to support the market, backed by steady inflows. However, one needs to also look at the offsetting factor which is the quantum of fresh paper supply. In CY24, MFs saw inflows of $45 billion in pure equity schemes. In the same period the total primary market paper supply stood at $70 billion.    Elara Capital flags that even if we assume 50 per cent of paper supply was taken by MFs, it would offset a big portion of MF inflows.  Another aspect is despite strong inflows in mid- and small-cap (SMID) schemes, the median fall in these shares was up to 50 per cent during the SMID correction of 2018-2020 period. The current leg of correction has also come with no slowdown in MF inflows.  That apart, the euphoria in Thematic/ Sectoral funds is already slowing down rapidly since September 2024. Many funds have started trading below their NFO price indicating investors are already sitting on losses. If prices don’t recover soon then the risk of bigger redemption opens. This will be a risk for stocks in Industrial, Manufacturing, PSU, Infra and Energy space where big money was raised in the CY23-CY24 period.  Near about 84% of mid-, small-cap stocks trading below 200-DMA  Technical data shows that more than 4 out of every 5 stocks in the Nifty MidCap 150 and the Nifty SmallCap 250 indices were trading below the key long-term moving average; i.e. the 200-DMA (Daily Moving Average).    Data shows that 122 out of the Nifty MidCap 150 stocks, and 212 out of the Nifty SmallCap 250 shares were trading below the respective 200-DMA as of Friday.  India's relative breadth v/s US coming off sharply  Indian and the US markets, according to the Elara Capital note, are trading like a mirror image. Over the last few years, India was seeing a massive breadth expansion while the US saw strong polarisation. For the first time since 2020, the US market breadth is turning better than India. Global asset allocators will now start playing breadth in the US where liquidity from larger names can start flowing into smaller stocks.