ETMarkets Smart Talk | Don’t mistake record highs for a broad rally: Why mid- and smallcaps are becoming increasingly selective, says N. ArunaGiri

Mid- and smallcap indices may be scaling fresh highs, but the rally is far from broad-based. Unlike the one-way momentum seen across the segment in 2024, the current market is being driven by sharp divergence, with investors rewarding companies delivering earnings growth and punishing those with weak earnings visibility.

In this edition of ETMarkets Smart Talk, N. ArunaGiri, Founder & CEO of TrustLine Holdings, argues that the record-high narrative masks a much more selective market underneath, where stock and sector-specific momentum is increasingly dominating.

With smallcaps also trading at significantly higher valuations than in previous cycles, the key question for investors is whether the current gains are backed by sustainable business prospects—or simply momentum feeding on momentum. Edited Excerpts -


Q) The headline story is interesting: Midcap and small cap indices are at fresh record highs, but the broader market has been consolidating for weeks. Are we looking at a healthy rotation beneath the surface or growing complacency?

A) Rotation rarely happens in a bottom-up stock-specific markets. It needs momentum markets. Rotation begins to happen when momentum becomes broad-based, particularly across the entire spectrum of small and mid-caps. That is not the case now.

Unlike the one-way run across the entire spectrum that we saw in late 2024, the current rally in small and mid-caps is very selective and stock specific.

Though the small and mid-cap indices are hitting lifetime highs, they are only a few percentage points above the highs reached in late 2024. As a result, one should not read too much into this life-time-high narrative.

With extreme divergence between winners and losers, there is no denying that there is an element of underlying complacency in the select set of stocks where momentum-begets-momentum appears to be at play.

Q) The biggest risk with record highs is that investors confuse momentum with quality. Are we seeing that happen again in parts of the mid- and small cap universe?

A) Markets at the small and mid-cap end have become very discernible. Their indices (mid and small cap) hitting lifetime highs do not tell the full story. In fact, they hide more than they reveal.

One is witnessing a very divergent trend within the small and mid-cap space, even as the indices trade near all-time highs. Momentum is not broad-based or across the board. It is very much stock and sector specific.

Companies that are delivering on earnings and have good earnings visibility are enjoying strong positive momentum, while the other set, where earnings visibility remains poor, is witnessing negative momentum.

In this context, it is interesting to note that the number of stocks hitting 52-week lows far outnumbers those hitting 52-week highs.

This is, therefore, a very choosy and divergent market, where the index performance masks a much wider divergence underneath.

Q) Are we entering another phase where investors are buying anything that is remotely linked to capex, defence, manufacturing, power or AI?

A) Now, in the current market setting, more than thematic plays, the market seems to be rewarding individual stock performance.

Earnings visibility and earnings upgrades are being handsomely rewarded, while the market is equally brutal in punishing negative earnings surprises. It is an increasingly discerning market now.

This is not the one-way momentum market that we witnessed during the year of 2024, when thematic stories such as railways and defence did extremely well as sectors, irrespective of individual company-specific performance.

Now, the market is more choosy and selective. It is in a mood to reward bottom-up, stock-specific ideas, where earnings delivery and visibility are beginning to matter more than the broader thematic narrative.

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Q) Can domestic liquidity permanently offset sustained FII selling, or are we underestimating the influence foreign investors still have on valuations and sentiment?

A) Domestic liquidity is no longer a transient phenomenon, as it was in the past. It has stood the test of time over the last two years+.

The fact that markets have withstood sustained FII selling for eighteen months, until June of this year, without caving in, is a clear testimony to the strength and persistence of domestic flows.

FII holdings in the listed space have come down sharply from 18%+ to 14%+ during this period, while DII holdings have spurted to over 18%.

That tells the underlying story. Domestic flows are no longer just a support story; they have become a main anchor for the markets.

This transformation has led to a very discernible shift in small-cap dynamics as well. Relative to previous cycles, the carnage in small-caps during the downcycle was far less pronounced in the last cycle - from December 2024 to March 2026 - than in earlier cycles, primarily because of this transition, i.e., the shifting of market control from FIIs to DIIs.

Further, this shift has also led to a noticeable increase in the average multiple in the small and mid-cap space relative to historical averages. In the past, even during upcycles, the aggregate small-cap index used to trade at around 20-25+ times trailing earnings.

Today, that multiple has moved up significantly to around 35-40 times in a normal cycle. This represents a very significant re-rating of the small cap space compared to previous cycles.

In our view, this is one of the most significant transformations in the markets in this cycle and is still not adequately appreciated by market participants.

Q) The market is now watching the US Fed closely. How sensitive is India to the possibility that US rates may remain higher for longer?

A) When FII flows into emerging markets were strong, India did not get its due allocation, primarily because the bulk of the global liquidity was directed towards the AI-led trade in the US and select Asian markets.

Consequently, FIIs do not have as much at stake in India today as they had in previous cycles. This is an important distinction.

If the EM tide were to reverse on the back of higher-for-longer US yields, the potential for FIIs to aggressively pull the plug on India is relatively lower, simply because their existing allocation to India is already much lower.

From this perspective, India is relatively insulated this time around from a sharp reversal in the global EM trade. That said, one cannot completely rule out sizable outflows, particularly through the currency and bond markets.

A sharp rise in US yields and a sustained higher-for-longer rate environment could have a negative sentiment impact on the rupee and G-sec yields, which, in turn, could trigger some portfolio outflows from India.

However, given the relatively lower FII ownership and the much stronger domestic liquidity base, the magnitude of such outflows and their impact on Indian markets could be significantly more contained than in earlier cycles.

In other words, while India may not be completely immune to a global EM risk-off, the transmission and the eventual impact on Indian equities could be much less pronounced this time around.

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Q) US Treasury yields have been moving higher, and historically rising yields tend to trigger a risk-off sentiment by making safe US assets more attractive and tightening global liquidity. How serious a risk is this for Indian equities, particularly expensive mid- and small caps?

A) This cycle seems to be playing out differently compared to earlier ones. Normally, in a global risk-off environment, the Dollar Index tends to strengthen, US Treasury yields soften as money flows back into US Treasuries, and safe-haven flows become pronounced.

This time, however, the risk-off environment is accompanied by a surge in US yields, even as the Dollar Index remains broadly flattish.

Interestingly, the Japanese yen has also firmed up of late despite the risk-off environment. This suggests that the traditional safe-haven flows are much less pronounced this time around, though the TINA factor will continue to support the US dollar and Treasuries as a safe-haven destination.

With respect to India, the rupee is likely to be more resilient going forward, given the large cushion from FCNR and other swap-related flows.

This, coupled with a relatively stable macro backdrop - with a resilient current account, BOP (Balance-of-Payment) and fiscal position - makes Indian markets much less vulnerable than in previous risk-off cycles.

While global risk-off conditions can still create volatility and some marginal outflows, the underlying macro resilience and stronger domestic liquidity provide a much larger cushion this time around.

Q) The IPO pipeline is exploding. Are investors buying businesses—or just buying the hope of listing gains? What is your view on the upcoming NSE IPO?

A) The IPO space, by its inherent dynamics, is always a hot space, with a huge tendency to overshoot, driven largely by herd behavior and the lure of a listing pop. That is simply the nature of the IPO beast. No surprise, therefore, that there is a lot of frenzy around IPOs.

Given our value bent, we generally stay away from this space, except that we use the better-quality IPOs for pipeline building and tracking purposes.

The NSE IPO, of course, is one of the largest offerings to hit the markets and is coming at a rather interesting juncture.

Unfortunately, it is coming at a time when pressures on derivatives volumes are rising amid tighter regulatory oversight and a changing regulatory regime.

Against this backdrop, it will be particularly interesting to watch how retail interest and participation play out in what is arguably one of the most anticipated IPOs in recent times.

Q) If you are sitting on 30-40% gains in mid and small caps, what should you do today- hold, trim or rotate?

A) I can understand the backdrop against which this question is being raised. It primarily stems from the surge in valuation in the small and mid-cap space over the last four months.

While there has undoubtedly been a spurt in small-cap valuations, one should not lose sight of the fact that this is happening after nearly eighteen months of downcycle in the broader markets.

Normally, when a cycle turns, it tends to last for an equal period, if not longer. Therefore, the question should not be about how much gain one is sitting on at this point. It is more about where the valuation and prospects stand from here.

As long as the underlying prospects continue to hold promise and valuations remain reasonable relative to those prospects, one should stay the course rather than prematurely taking action simply because a position has done well in the recent past.

In our view, such decisions need to be taken on a stock-specific basis, with primary emphasis on the valuation and prospects of the underlying business. A detailed due diligence of the valuation–prospects matrix is critical before taking any action - be it holding, pruning or trimming a position.

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)