The strongest end of the market, the mid-caps, had been looking a bit uncomfortable since last Friday. Even as the Nifty broke past 6,200 on Friday, the advance-decline ratio did not look convincing and yesterday mid-and small-caps saw a serious selloff. This space has to be watched closely as the genesis of the current market momentum lies in the heady mid-cap rally of the last quarter.
Between November 1 and January 1, the BSE small-cap index rose 42 per cent. The CNX mid-cap index rose 28 per cent while the Sensex was up barely 3 per cent. Such has been the extent of outperformance of the broader market compared to large-caps. The yawning valuation gap between large-and mid-caps got closed out to a considerable extent in this period; in fact, there are clear signs of froth in many mid-cap pockets. Maybe not as much as small-caps, where the rally in most parts is inexplicable and undeserved.
Yesterday's selloff is signalling one of two things. One, such serious outperformance has made relative valuations look better in large-caps and the action is rotating to index heavyweights. Such rotation would be positive and generally ends in market levels sustaining and edging higher.
Alternatively, the rally that started in the last quarter of 2007 with mid-caps is now tiring out and the first signs are visible in the very space where it all began. While the first scenario has a higher probability, one should not ignore the second possibility altogether till there is a confirmation from the market. It is true that a single day's selloff is too little to undo the relentless strength of the last two months, yet turbulence at elevated levels should not be treated lightly. Better safe than sorry.