(March 14): A sharp correction in small-cap stocks portends souring risk appetite on the broader Indian market, which is now an underperformer in Asia Pacific after a multi-year rally.

An index of small-cap stocks lost more than US$80 billion (RM375 billion) in market value in less than two weeks through Wednesday after authorities flagged risks of overheating and guided funds to limit purchases. Small- and mid-cap stock gauges of the Bombay Stock Exchange rebounded Thursday after plunging more than 4% each in the prior session.

As sentiment weakens, investors are pulling money out of richly valued larger shares as well. The MSCI India Index is now lagging behind MSCI’s Asia Pacific index for a second straight month, with markets such as Taiwan and South Korea more in favour due to their exposure to chip shares and the artificial intelligence (AI) boom. Some investors anticipate losses will deepen.

“The regulatory actions against small cap stocks are testimony to the valuation froth in India,” said Nitin Chanduka, a strategist at Bloomberg Intelligence. “India could continue to underperform Asia going into the national elections in the next few weeks and amid the chip rally in other markets in the region.”

MSCI’s India gauge is trading at 22.7 times its one-year forward earnings, which is at a premium of 58% to a similar gauge for Asian stocks, according to data compiled by Bloomberg.

The Securities and Exchange Board of India has been concerned about large flows into small- and mid-cap stocks amid an outsized rally in the riskiest area of the nation’s US$4.3 trillion market over the past year. Late last month, it asked funds to come up with measures to moderate inflows into related plans and safeguard investors from sudden redemptions.

“It may not be appropriate to allow bubbles to keep building because when they burst, they impact investors adversely,” Chairwoman Madhabi Puri Buch said earlier this week. Sebi is open to allowing money managers to hold more large-cap stocks in their small-cap portfolio to manage risk, she said.

Buch further said the regulator has observed “patterns of price manipulation” in new listings taking place on platforms for tiny companies. The souring mood is affecting debuts in India this week, with the three latest initial public offerings declining as much as 16% in their first trading days versus an average gain of 20% this year through Wednesday.

In light of the regulator’s remarks, ICICI Prudential Asset Management Co on Tuesday said it will temporarily halt lump-sum deposits in its mid and small-cap funds starting Thursday. Last month, Kotak Asset imposed limits on flows on recurring plans in its small-cap fund, citing the sharp surge in this segment that has led to “valuation distortions” in some cases.

The S&P BSE Small Cap Index is down more than 11% from an all-time high reached earlier this year. Some investors used the declines to load up on shares as market participants overall remain bullish on Indian equities. Domestic institutional investors including mutual funds and insurance companies plowed a record US$1.1 billion into local shares on Wednesday, exchange data showed.

Smaller stocks led the record-breaking rally in the Indian equity market in the past year, which forced foreign funds to look beyond the typical large cap names. Retail investors, however, have dominated the space as their holding in stocks of NSE’s Nifty Smallcap 100 Index rose to 15.4% in December from 12.5% in March 2019, according to Kotak Securities.

The breathtaking rally in the small-cap segment saw more than five stocks return over 1,000% in the two years ending December, while 23 stocks rallied over 500% in the same period, data compiled by Bloomberg show.

“Most mid- and small-cap stocks are still trading at full-to-lofty valuations and well above their fundamental value,” Sanjeev Prasad, co-head of institutional equities at Kotak Securities, said in a note. “Many low-quality stocks may still have a long way to fall.”