Current rally: Wait, vet and buy

In the past one-and-half months,the Indian equity market has been in the midst of a strong rally. In the last 23 trading sessions beginning March 9—when the market had hit a near bottom—NSE Nifty has rallied by nearly 35%, surprising most investors and market observers since then. Initially billed as a relief rally, it is now acquiring all kinds of nomenclature on its way up.While some dismiss it as just another bear market rally which will fizzle out soon, a growing section sees it as the beginning of a new bull-run. Their argument is that risk taking is back in vogue and investors are gradually regaining their faith in equities. This puts retail investors in a tight situation, especially those who are still waiting for a decisive market move.So,what does an investor do? One way to measure the strength of the rally is to contrast and compare the relative gains made by various categories of stocks. The universe of listed companies can be divided into three categorieslarge-cap , mid-cap and small-cap stocks—for analytical purposes.A recent report by Morgan Stanley Research says that the bear market tends to increase focus on quality of earnings.This puts the spotlight on large-cap companies, which are also the best and brightest of India Inc. They are expected to have the best earnings metrics in the market.Besides, large-cap counters are widely tracked and analysed by various brokerages and fund houses. In contrast, small- and mid-cap companies are mostly industry laggards with questionable earnings quality. Moreover, these companies are thinly covered by the street think tanks, making them vulnerable to manipulation.This puts the onus on large-cap companies to initiate and lead the rally. However, as the rally gathers strength, it has a rub-off effect on smaller companies, and they also join the party in the later phase. However, as the market enters the bubble zone, mid-cap and small-cap counters begin to break free from the shadows of their larger peers.Their stock prices acquire a momentum of their own and begin to outperform the benchmark indices, which comprise the leading stocks. This outperformance is seldom matched by fundamental factors.In fact, betterthan-expected gains by small-cap stocks are often a precursor to a major market correction.This was the case in the last quarter of 2007, which witnessed an nprecedented rally that ended in one of the worst crashes in Indian market’s history.

The lessons for retail investors are clear; pack your bag when the party gets too crowded.So what’s the current status of the party?The dance floor is still less crowded than what it was in the last two months of 2007.In the past one week or so, the Mid-cap Index has begun to outperform its larger peers,but the divergence is still marginal. TheSmall-cap Index continues to underperform the benchmark index.The current rally is still to acquire the status of a bubble and may last little longer.This may provide some hope for the fence sitters, but it’s always dangerous to swim at the edge of a steep fall. Given this, retail investors are advised to stay away and buy stocks on dips.If three months ago, most largeand mid-cap stocks were available at a deep discount to their fair value, now that discount has either vanished or has become marginal.This calls for a cautious approach.
source:E.T