Small caps in India have been lagging for most of the year, with that trend really accelerating in May, posing a major headwind for the broader market. One thing we were looking for before putting cash to work on the long side was signs of risk appetite for stocks, which we're seeing for the first time in a while. The question now is whether it will last and how it affects our portfolios?

Below is the Nifty 100 relative to the Free Float Smallcap 100, which we're using to track this relationship of large-cap versus small-cap performance. In early October, it pushed to nearly 4.5-year highs, but it quickly reversed to confirm its bearish momentum divergence and a failed breakout.

This is an interesting change of character since all the potential bearish divergences we've seen this year were worked off through time, rather than corrective price action. This one, however, was not.

Chart showing performance of the Nifty 100 relative to the Free Float Smallcap 100

So what does it mean from a practical standpoint?

In the short term, it means that the trend of large-cap outperformance is at least due for a pause. It would be irresponsible to be long this ratio if it's below 1.772, so we'll have to wait to see if this failed breakout works itself off through time or by correcting further in price.

Secondly, small caps outperforming, or at least performing in line with their large-cap counterparts, will continue to support the bounce in stocks that we wrote about on Monday. From a portfolio management perspective, we can express the development in this ratio by being short if it's below 1.772 or simply overweighting small caps.

Whether you're putting on this pairs trade or using it for informational purposes, I think this relationship is an important one to keep an eye on.

Thanks for reading, and let us know your thoughts!

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