The Indian Large Cap - Small Cap Breadth Divergence is Unsustainable

While the largest 50 stocks in India have bucked the downward trend found in most emerging markets year-to-date, India’s mid and small cap stocks have not.  Coming into 2018, the valuation levels of such stocks were pushing extreme levels.  This year has now scene a dramatic reversal of fortune between large and small cap stocks with the latter dramatically underperforming the former.  Relative valuations have been restored to more normal levels.  Presently, 56% of the Nifty 50 Index members are trading above their 200-day moving average compared to only 24% of small cap stocks.  This size of a breadth divergence is indeed rare and has only occurred two other times over the past ten years.  This can be seen on the chart below where we subtract small cap breadth from large cap breadth.  Both times preceded a mean-reversion trade between the two capitalization strata.  We think a third time is upon us.   

From a strategy perspective, the “trade” is to go long small cap Indian stocks while short large cap Indian stocks.  From a fund management perspective, we have been rotating out of large cap names and into smaller cap names gradually and will likely continue to in the near future.