Caution: This post is heavy on statistics
Yesterday when Sensex hit new high while mid and small cap stocks remained in bear territory, I began to wonder if this is the first time such a thing has happened and what can be possible reasons behind it. Besides the reasons listed in my earlier post, I decided to use number crunching to see if there is any explanation.
Movement in stock indexes can be broadly explained by two factors, trend and shock. We know that stocks go up over long term and over the last 25 years Sensex has gone up at a CAGR of 12%. That’s the trend growth. But the journey hasn’t been in a straight line because market was hit with a series of shocks which caused Sensex to trade way below or way above the trend line. Over time, these shocks recede and market returns to trend level only to get hit with another set of shocks.
As investors we are interested in knowing if the market has gone too far away from trend as a result of these shocks. In other words, we are not interested in the trend growth (as it is predictable) but the shocks as these are unpredictable.
I used a statistical technique called Trend Stationary Time Series analysis to remove the trend component in Sensex so that the residual will represent purely the shock component. I then calculated the ratio of actual Sensex value and trend value to know the effect of shocks. I performed the same analysis for Small-Cap index. Chart below shows Actual / Trend lines for these two indices.
A value of 1.22 means that Sensex is trading 22% above (+ve shocks has pushed the Sensex above trend) trend while a value of 0.6 means Sensex is trading 40% below the trend line due to -ve shocks.
As you can see in the chart above, Small-Cap index is significantly more volatile than Sensex. At the peak of 2008 bull market, it reached as high as 170% above trend. In 2013, the small cap index reached about 40% below trend almost as much as the trough reached in 2008 crisis. No wonder there were bargains in small cap stocks in 2012-13.
Sensex on the other hand has seen volatility drop by a huge margin since the 2008 crisis. Prior to that, index used to trade way above or way below trend, but in last 7 years, Sensex reached 22% above trend only once at the peak of 2014-15 Modi rally. Other than that is trending close to trend value i.e. neither going too much above the trend nor going too below trend.
In 2017, the euphoria in small and mid cap stocks pushed the small cap index (and Midcap index) to as high as 26% above trend while Sensex was trading withing +/- 5% of trend. Only time Smallcap index traded this high above trend was prior to 2011 when economic stimulus caused stocks to rebound from crisis low. As the euphoria receded, small caps went down in 2018 and now trading close to long term trend value. Since Sensex was always trading close to trend value in 2017 and 2018, there was no fall in Sensex.
Only other time, a similar move happened was towards the end of 2010 when small caps began to crack while Sensex was trending up. Although at that time both indices were way above the trend value so in 2011, both went down together. While Sensex stabilized around the trend line, momentum and liquidity squeeze carried the smallcaps further down to crisis level.
On the other hand, in 2015, Sensex went down more than small and mid cap stocks as large caps that were pushed higher in Modi rally returned to trend levels while mid and small caps were already trading trend level as they had barely recovered from 2013 liquidity squeeze.
Some of the factors that were at play (Fed taper, current account deficit, FII running away, rupee crashing) in 2013 are also at play in 2018. However momentum is not as strong so we may not see 2013 like valuations in 2018. even if we do get to that level, 2013 turned out to be a great time to pick small and mid caps and 2018 might as well.