Midcap, smallcap rally has eroded margin of safety, rotate to largecaps: Axis Direct's Rajesh Palviya

The sharp three-month rebound in midcap and smallcap stocks has left investors with little room for earnings disappointments, prompting Axis Direct to favour a selective shift toward largecaps. Rajesh Palviya, head of research, says Nifty50 valuations are near their long-term average, offering better comfort for fresh allocations than increasingly expensive pockets of the broader market following their recent surge now.

Edited excerpts from a chat:

Axis Securities has a December 2026 Nifty target of 28,100. With the index around 24,300, what needs to change—earnings, liquidity or valuations—for the market to deliver that upside? What are your bull- and bear-case targets now?

For the market to deliver further upside, the focus now shifts to corporate earnings delivery and companies' ability to defend margins against elevated input and logistics costs. Further valuation re-rating will hinge on currency stability, a well-distributed monsoon, and a complete resolution of Middle East geopolitical tensions.

We have revised our base-case December 2026 Nifty target to 27,220 (valuing the index at 19.5x December 2027 earnings), as published in our latest July 2026 Monthly Top Picks report.

Bull-Case Target: 28,615 (20.5x), driven by a strong revival in private capex, rural recovery, policy continuity, and easing global tariff uncertainties.

Bear-Case Target: 23,030 (16.5x), triggered by sticky global inflation, prolonged elevated interest rates, a monsoon deficit, and trade or geopolitical disruptions that compress multiples.

What are the early trends you are noticing in the Q1 earnings season? Are the numbers indicating the earnings revival the market has been waiting for, or are stock prices still running ahead of fundamentals? Which sectors have the greatest scope for upgrades and downgrades?

Q1FY27 earnings mark a gradual but mixed corporate revival, with the Nifty poised to return to double-digit growth via an estimated 11.2% YoY PAT expansion. Rather than prices running ahead of fundamentals, the market is undergoing a healthy recalibration — the Nifty 50 has corrected to trade near its historical average of 18x forward earnings, and its valuation premium over emerging markets has cooled to a far more attractive ~50%.

While downside risks appear well-contained, a sustained directional rally will require clearer macro stability and an acceleration in earnings. Until then, expect a range-bound market driven largely by stock-specific plays.

Within this backdrop, strong earnings momentum is visible in domestic-facing sectors such as BFSI, Telecom, Utilities and Pharma. Near-term pressure and downgrade risk, on the other hand, remain concentrated in IT Services (on cautious global demand), Cement (squeezed by high fuel and freight costs), and Agrochemicals (delayed by the monsoon).

FIIs returned strongly in early July after four months of heavy selling, but they have again sold on several consecutive sessions. Is their return structural or merely a tactical trade? Which indicators would convince you that foreign investors are rebuilding long-term India positions?
Current FII flows remain predominantly tactical rather than structural, constrained by global monetary policy uncertainty, the relative appeal of developed markets, and earlier concerns over elevated domestic valuations that drove nearly $13 billion in FY27 YTD outflows. The pace of selling has recently eased as India's valuation premium over emerging markets cooled back to its historical average of ~50%, but foreign allocation remains highly sensitive to global macro shifts.

For us to call this a structural rebuilding of long-term India positions, three conditions need to fall into place:

1. Energy and inflation relief — a sustained moderation in global crude prices to ease fiscal and margin pressure.

2. Fundamental support — clearer corporate earnings visibility and demonstrated ability of companies to defend margins against domestic cost pressures.

3. Macro stability — a stable rupee alongside lower global bond yields to reverse risk aversion.

Until these align firmly, foreign flows will likely stay range-bound and selective in nature.

What are your client recommendations when it comes to investing in IT? Do you see it as a contra trade or too risky at this stage?
We view IT as a selective, long-term contra play rather than an immediate broad buy — structural anxieties around AI-led disruption keep the medium-term outlook cautious. That said, deep valuation compression provides a reasonable margin of safety: the sector index has corrected 49% from its September 2024 peak to trade at a 12-month forward P/E of ~14.9x, well below its long-term average of 20.7x, while its valuation relative to the NASDAQ 100 has slipped to a low of 0.58x.

Near-term fundamentals remain soft — Q1FY27 profitability is likely to stay under pressure from cautious global spending, wage hikes and rising AI-related investments, which together drove a sharp 9% downgrade to the sector's FY27 Nifty EPS estimates post-Q4.

Our advice to clients: avoid chasing tactical momentum and instead use bouts of localized volatility to accumulate high-quality, well-capitalised businesses through a disciplined, bottom-up approach over a 12–18-month horizon.

Mid- and small caps are performing well. Do the charts and market breadth justify continuing to buy the broader market, or should investors now rotate towards large caps? Where do you see the biggest pockets of excess?
Market breadth remains structurally supportive of broader participation — 93% of sectors have outperformed the frontline indices in FY27 YTD, even as a modest 46% of NSE 500 stocks trade above their 200-day moving average. That said, the sharp three-month rebound in mid- and small caps has meaningfully narrowed their margin of safety.

We see pockets of excess building precisely in these smaller segments, where aggressive rallies leave limited room for disappointment. A selective rotation toward large-caps looks prudent, given frontline equities now offer relatively better comfort with the Nifty50 trading near its long-term average of 18x forward earnings.

Rather than buying the broader market indiscriminately, investors should favour tactical sector rotation and a disciplined, bottom-up Growth at a Reasonable Price (GARP) approach — anchoring portfolios in high-quality large-caps with strong balance sheets and clear earnings visibility.

Crude oil, the rupee and continuing West Asia tensions remain major external risks. At what oil price or currency level would the market's bullish setup become vulnerable?
The market's bullish setup would come under strain if crude oil surges back toward its recent peak of 100/barrel,or if the rupee meaningfully breaches the 96/ mark.

History offers a useful reference: during the recent West Asia crisis, crude touching $100/barrel stoked inflation anxieties, pushed the 10-year Indian G-Sec yield to a peak of 7%, and triggered a sharp ~15% correction that took the benchmark down to a low of 22,331 in March 2026. Subsequent de-escalation cooled Brent to ~$72/barrel and stabilised USD/INR near 95.

Any renewed geopolitical flare-up that pushes energy prices back toward those earlier highs would squeeze margins across fuel-intensive sectors, pressure the current account deficit, and risk dragging domestic GDP growth below 6.5%, effectively exposing the market to our bear-case target of 23,030.

If an investor had fresh money to deploy today, how would you divide it among large-, mid- and small-caps?
Allocations to mid- and small-caps should be selective and measured. After their sharp three-month rebound, valuations in this space leave a narrow margin of safety and little room to absorb earnings disappointments.

Large-caps, by contrast, now offer superior relative comfort, with the Nifty50 trading close to its long-term average of 18x forward earnings making them the preferred anchor for fresh allocations at this stage.

Which three sectors would you overweight, which would you avoid, how much cash would you retain, and would you invest immediately or stagger purchases over the next few months?
Our strategy centres on Growth at a Reasonable Price (GARP), quality businesses, market leaders, domestically-oriented sectors and selected export plays. Specifically, we:

1. Overweight: BFSI, Telecom, Capital Goods, Healthcare, and Power & Energy.

2. Stay constructive on select discretionary and retail consumption names.

3. Prefer select capex-linked cyclicals, which now offer attractive valuations with reasonable growth visibility.

4. Stay cautious on IT in the medium term, given the overhang of AI-led disruption.