Froth rising? Midcap and smallcap valuations on brink of overflow

Liquidity and earnings the midcaps' moment of truth

The market capitalisation of midcap and smallcap stocks as a percentage of India’s gross domestic product (GDP) has reached record-high levels.

According to an analysis by Motilal Oswal, the market capitalisation-to-GDP ratios for midcap and smallcap stocks are 27 per cent and 29 per cent, respectively. These figures exceed their 20-year averages of 13 per cent for midcaps and 11 per cent for smallcaps.

In the pandemic-affected year of 2019-20, the market capitalisation-to-GDP ratios for midcap and smallcap stocks were only 9 per cent and 5 per cent, respectively. Stocks in this segment have experienced exponential growth, raising concerns about potential froth.

The overall market capitalisation-to-GDP ratio for all listed companies is also elevated at 146 per cent, compared to a long-term average of 85 per cent. While this valuation metric raises concerns, it may not necessarily trigger a market correction on its own.

“It is tough to predict whether midcap capitalisation as a percentage of GDP will decline. It will depend on liquidity and underlying earnings growth,” said Gautam Duggad, head of research for institutional equities at Motilal Oswal Financial Services.