Flight to quality

The Indian stock market (Sensex) is going up, up and away. But this phenomenon is largely driven by a handful of heavyweights, mostly the Sensex stocks that are participating in this rally; the other shares are hitting lows. This divergence typically appears in phases where investors are risk-averse and prefer quality over growth. So Business India took stock with a few of the market participants to find out what their reading is.

“This is classic — we have had a narrow rally led by large-caps and index heavyweights in CY25, while mid- and small-caps and broader stocks lag or correct. It’s a healthy reset after the runaway rally of prior years. In 2020-24, especially in small-caps, which ran way ahead on valuations. Now, earnings visibility is still single-digit and hence we are seeing corrections in valuations,” explains Nilesh Shah, MD, Kotak Mahindra Asset Management Company (AMC), who feels that broader participation will come only when earnings rebound meaningfully. He expects earnings, adjusted for the one-time effect of the labour code and rupee depreciation, to be low double-digit in FY27.

“Stay patient – like Test cricket, build innings steadily, do not chase every ball. The Sensex holding up shows underlying strength in quality large-caps, but do not expect a uniform up-move yet,” suggests Shah.

“The divergence between the Sensex and the broader market reflects a clear risk-off phase in equities. Ongoing global uncertainties and recession concerns have driven investors towards the relative safety of large-cap stocks with stable earnings and strong balance sheets,” says Ashutosh Shirwaikar, Head of Investment, Navi AMC, adding that “FII flows have been volatile, and their selling tends to disproportionately impact mid- and small-cap stocks. Valuation concerns in the mid- and small-cap segment have also resulted in caution and profit-taking, while steady DII inflows have helped support large-cap indices. Overall, this points to weak market breadth and a cautious investor stance as markets await clearer economic signals.”

“This tells us investors are still playing it safe, sticking to large, liquid names with stable earnings rather than taking broader market risk. Mid- and small-cap stocks, which are more exposed to global liquidity swings and domestic growth sentiment, have been left behind. Add to this passive index flows, and you get a situation where the indices look healthy, but the underlying market participation remains quite weak,” says Sachin Sawrikar, Founder and Managing Partner, Artha Bharat Investment Managers.

According to Anand K Rathi, Co-Founder of MIRA Money: “What we are witnessing is not unusual in market cycles. An index like the Sensex or Nifty represents a weighted average of stocks based on market capitalisation, not the experience of the median stock. Over the past year, while the Nifty may have delivered positive headline returns, the median stock performance has actually been weak, with many stocks correcting sharply. For instance, even when the index was up around 10 per cent, the median stock was down close to 8 per cent, which clearly shows how narrow the market participation has been.” He feels that this divergence typically happens both in late-stage bull markets and during consolidation phases. In strong bull phases, the median stock often outperforms the index, while in maturing or corrective phases, leadership narrows and index heavyweights dominate. “This is not a sign of market dysfunction, but a normal part of market evolution,” he adds.

“The current market movement is clearly index-led rather than broad-based. Large-cap stocks, especially select financials and metals, are attracting incremental flows due to their balance sheet strength, earnings visibility and global relevance. On the other hand, mid- and small-cap stocks have underperformed due to valuation excesses, earnings downgrades and tighter liquidity conditions,” states Gaurav Bhandari, CEO, Monarch Networth Capital.

Structural slowdown

The Indian economy is in a structural slowdown despite an official GDP growth rate of 8 per cent, which is somewhat reflected in an abnormally low inflation print of one per cent. “In a healthy demand environment, inflation would be 4-6 per cent. Corporate annual EPS growth has derated from near 25 per cent during FY24 to 8-10 per cent at present. On the other hand, valuations have hardly adjusted to changed realities, with small-cap and mid-cap benchmarks still trading at P/E multiples of 30x, that too after a near 15-20 per cent correction in the small-cap benchmark from the highs of December 2024,” observes Ankit Agarwal, MD of Alankit, who feels that when it comes to the Sensex or Nifty 50, valuations are relatively more attractive in the range of 22 to 23 times, though historically, in the absence of EPS re-rating, investment at even these relatively low valuations has delivered sub-optimal returns (in the range of 1-3 per cent).

“Relative valuation comfort from the Sensex is triggering a time correction where investors are willing to live with low single-digit returns for a few quarters in wait of EPS re-rating. On the other hand, valuation froth in the broader market cannot be addressed by time correction alone and hence they are dealing with sharp price correction as well, which explains the present dichotomy between the performance of the Sensex and broader markets. Price action in the market at present is strictly driven by a bottom-up approach, where good earnings and reasonable valuations are rewarded by investors,” adds Agarwal, citing that metals, banks and NBFCs have been major outperformers in 2025 as good-quality names in these sectors were available at a deep discount to broader markets.

The market has turned excessively volatile recently in response to unprecedented geopolitical developments. “Large-caps are resilient compared to mid- and small-caps. This is because there is valuation comfort in large-caps compared to mid- and small-caps. In 2025, while the Nifty delivered 10 per cent returns, 275 stocks in the Nifty 500 delivered negative returns. Excessive valuations are weighing on mid- and small-caps,” says VK Vijayakumar, Chief Investment Strategist, Geojit Investments Limited.

Budget blues

On 1 February 2026, Finance Minister Nirmala Sitaraman will announce the Union Budget, which is said to be a ‘reform express’. The overarching objective is to simplify regulation, enhance competitiveness, strengthen domestic manufacturing, and align institutions, skills and delivery systems with India’s long-term growth ambitions.

“It should focus on achieving the impossible trinity: raise non-tax revenue through asset monetisation, tax revenue through better compliance, continue the capex push and follow the path of fiscal prudence,” says Shah, who does not expect big-bang giveaways, but adds that there could be targeted relief – media reports talk about possible tax concessions on long-term capital gains (LTCG) for tax-exempt FPIs or rationalising the double taxation of dividends. “If that happens, it would be a positive signal and could trigger FII reassessment. Overall, expect continuity on reforms, not fireworks – but even stability helps when earnings start improving,” suggests Shah of Kotak.

“STCG (15 per cent) and LTCG (10 per cent above Rs1 lakh) are likely to remain unchanged to preserve market stability. A rollback or reduction in STT is unlikely, given its steady revenue contribution and ease of collection; revenue from STT for FY26 is projected at Rs78,000 crore and remains a significant contributor to government revenue. Already, the government has reduced the GST rate in the middle of FY26 to spur consumption demand, and this has led to Rs50,000 crore of revenue forgone,” says Vishad Turakhia, MD and CEO at Equirus Securities.

“In our view, the Union Budget may be neutral overall, given that only last year we had a host of tax reliefs followed by GST cuts in mid-FY26. Given the need to stick to a path of fiscal prudence, it may be difficult to do too much incremental hereon. What we could see is some degree of targeted incentives – for example, certain tariff-impacted sectors like textiles, gems and jewellery, marine products, etc, could see some benefits. Incentives for more R&D and innovation spend may be other areas of focus,” says Jitendra Sriram, Senior Fund Manager – Equity, Baroda BNP Paribas Mutual Fund.

Sawrikar of Artha Bharat Investment Managers feels that while the Union Budget will not directly drive equity markets, investors seek signals of fiscal discipline, policy continuity and growth support amid global uncertainties. Rationalised capital gains taxes, long-term savings incentives, or deeper domestic capital markets would boost sentiment. Crucially, avoiding negative surprises ensures stability, prioritising predictability over short-term stimulus.

Providing meaningful relief at this stage would require out-of-the-box thinking. The government has already used a significant portion of its fiscal ammunition over the last few years. “Any large stimulus now would likely mean either increasing the fiscal deficit or compromising on the fiscal glide path,” adds Rathi, not expecting policymakers to do so. “Instead, the focus is likely to remain on compliance, efficiency, and better transmission of existing tax structures such as GST. Unless something completely unexpected is announced, I do not foresee major direct relief for investors in the near term. The government’s priority appears to be macro stability rather than short-term sentiment management,” says Rathi of MIRA Money.

“If the government intends to protect market sentiment and retail investors, key relief would be the removal of double taxation on dividends and the rationalisation of long-term capital gains (LTCG). Direct tax reforms would have a stronger impact than incremental spending measures,” suggests Sunil Pachisia, Director, Pratibhuti Vinihit Ltd.

Historically, dividend taxation was introduced to curb tax arbitrage by private companies. That issue was more relevant years ago. “At this point, it is not a dominant concern impacting market behaviour, and its broader implications need clearer data before drawing strong conclusions,” says Rathi.

Historically, dividend taxation was introduced to curb tax arbitrage by private companies. That issue was more relevant years ago. “At this point, it is not a dominant concern impacting market behaviour, and its broader implications need clearer data before drawing strong conclusions,” says Rathi.

There is a valid regulatory concern around excessive speculative activity in equity markets. “A fair way to do things would be to punish short-term speculators and reward real long-term investment,” adds Rathi, suggesting an idea to make LTCG tax-free but raise the holding period from one year to two or even three years. This would encourage patience, improve capital formation, and ensure that equity investing remains aligned with long-term wealth creation rather than short-term trading behaviour.

Resource constraints

Bhandari says: “The current structure does raise concerns, particularly for long-term investors. Double taxation dampens post-tax returns and reduces the attractiveness of equities as a long-term asset class. Rationalising this framework, either by adjusting rates or providing holding-based incentives, would significantly improve investor sentiment and participation.”

Investors can ask for tax reliefs, but one should also consider the resource constraints of the government. The government is running a fiscal deficit of 4.4 per cent of GDP, and the government debt-to-GDP ratio is 81 per cent. “Under these circumstances, it would be unrealistic to expect more tax reliefs. Also, it is important to understand that it is not high taxes that are weighing on the stock market; it is poor earnings growth. When corporate earnings improve, hopefully in FY27, the market will respond positively,” observes Vijayakumar of Geojit Investments.

Technically, LTCG can be made tax-free by increasing the holding period to 2-3 years. Possible in theory, this could encourage longer-term investing and reduce short-term churning. But making it fully tax-free might be tough fiscally. More likely are tweaks such as rate rationalisation or exemptions for certain categories (eg, foreign institutions via treaty). “This could help sentiment hugely if announced in the Budget – many global investors cite double taxation (LTCG plus dividends) as a concern. Watch 1 February closely,” adds Shah.

So can LTCG be made tax-free by increasing the period of holding to 2-3 years? Says Sriram: “This may be a possibility. On the positive side, retail interest in equities is definitely on the rise, going by the growing SIP book. However, there have been on-and-off worries about speculative activities (eg, derivative positions) being taken by certain retail investors who are probably not as well versed in the risks of such leveraged bets. To induce and incentivise a long-term savings culture via equities, this could logically be a step to migrate towards a longer-term horizon away from speculation.”

Another big dampener on the market is the large FPI/FII outflow. How can we arrest it? “We need some amount of luck. Normally, investors take money out of the USA when the dollar depreciates. In CY25, investors poured $1.8 trillion into US assets despite the DXY going down over 10 per cent. Will investors repeat history? If yes, then money can flow to emerging markets, including India,” points out Shah.

In fact, Chinese markets have done well in the last 2 years but are trading at a level last seen 17 years ago. Over the last three decades, Chinese markets have gone up five times and come down five times. “Will history repeat and will the sixth ascent be converted into a fall? If yes, EM flows can move towards China,” suggests Shah, who apart from ‘luck’ also says: “We need to manage perceptions. Global media is persistently biased against India. They lie openly without any consequences. Very recently, I wrote to a global media house about a factual error in their report which said that the Government of India is targeting a 50 per cent debt-to-GDP ratio by 2031 from 81 per cent in 2026. Very conveniently, they ignored that 81 per cent is the combined debt of the Centre and states, and 50 per cent is only the central debt. We need to show the truth to the world.”

Meanwhile, FIIs continue to sell Indian equities largely due to global risk aversion, a strong US dollar impacting rupee-adjusted returns, and relatively premium valuations in India compared to other emerging markets. The last 18 months have seen a large amount of FII unwinding.

“Declining post-tax returns in comparison to other Asian markets may be one factor. This is a combination of weaker corporate earnings, rupee depreciation and the annulling of a number of bilateral investment treaties (BITs). In our view, the government could look at certain easing of FII/FPI taxation where the end beneficiary is clearly identifiable – for example, sovereign wealth funds, retail mutual funds, etc. This also dovetails and reduces the risk of Indian money being round-tripped,” says Jitendra Sriram, Senior Fund Manager – Equity, Baroda BNP Paribas Mutual Fund.

Corporate earnings growth

“But moderation in corporate earnings growth, heightened geopolitical uncertainty, and more attractive opportunities in markets such as China, Taiwan, and Korea have further diverted foreign capital away from India, despite strong domestic economic fundamentals,” adds Shirwaikar of Navi AMC.

Firstly, the rupee needs to stabilise. USD-INR was stable and hovering around R83-86 at the same time last year before climbing to 91.5 recently. Secondly, the India-US trade deal should see a promising direction, which would be read positively by FPIs. “Regulatory and policy clarity is a must for FPIs to participate; no surprise capital gains or withholding shocks should come in the Budget. India’s growth differentials versus global peers have historically supported FPI participation. Broader index inclusion over time can also deepen structural allocations,” says Turakhia.

Meanwhile, FIIs persist in selling Indian equities amid intertwined global and domestic factors undermining relative returns. “Elevated US interest rates, a resilient dollar, and constrained global liquidity render developed market assets far more appealing on risk-adjusted metrics. Concurrently, rupee depreciation sharply diminishes dollar-denominated gains, while lingering tax ambiguity on capital gains amplifies caution. With earnings poised for gradual, uneven recovery, favouring only firms with robust balance sheets, pricing power, and global exposure, FIIs opt to dial back, reallocating to markets boasting superior visibility and near-term risk-reward profiles,” adds Sawrikar.

Market participants are looking at overall expectations for corporate results in FY27. “We should see lower double-digit earnings growth adjusted for the one-time effect of the labour code and rupee depreciation hit – after six quarters of single-digit Nifty 50 earnings. Structural tailwinds in financials, consumption (via digital and tech platforms), auto and cement. Broader recovery as policy reforms from 2025 (tax, GST, labour) bear fruit, the capex cycle sustains, and macros stay supportive (low inflation, steady GDP). Not explosive, but solid double-digit – that’s what will drive broader market participation and an FII comeback. Temper expectations: high single- to low double-digit market returns are realistic, not 20 per cent-plus every year,” says Shah.

Turakhia of Equirus Securities feels that “in FY26, corporate earnings showed early signs of stabilisation after a period of muted growth, with several sectors reporting improved quarter-on-quarter performance and earnings upgrades emerging late in the fiscal. Earnings momentum is likely to strengthen further in FY27 as cyclical pressures ease and volumes recover.”

Corporate earnings in 2026-27 should see gradual improvement, supported by operating leverage, lower interest rates, easing input costs, and a pickup in consumption driven by GST rationalisation and lower income tax rates. “But performance is likely to be uneven across sectors. Companies with strong balance sheets, pricing power, and global exposure are better placed to outperform, while highly leveraged firms and purely domestic cyclical businesses may remain vulnerable to volatility. Much will still hinge on global growth trends, commodity prices, and financial conditions. Overall, earnings expectations should be constructive but measured, rather than overly optimistic,” suggests Sawrikar of Artha Bharat Investment Managers.

Expecting moderate but higher-quality earnings growth, Kumar Binit, CEO at Airpay Money, says: “The key drivers are financial services: credit growth with improving asset quality; manufacturing and capital goods: capex cycle continuation; consumption: gradual recovery led by urban and premium segments. Margins may remain under pressure in some sectors, but balance sheets are far stronger than in previous cycles. Overall, earnings visibility is better than headline growth suggests.”

“Given geopolitical uncertainties and visible slowdown in consumer spending, Q4 FY26 and Q1 FY27 will be crucial. If Budget expectations are met, a broader rally and earnings recovery are possible; otherwise FY26-27 could remain challenging,” says Pachisia.

Sriram of Baroda BNP Paribas Mutual Fund feels that at this point in time, the benchmark indices like the NSE100 are forecast to deliver low-teen earnings growth into FY27, driven by a combination of lower base effects, strong real GDP growth, and a softer monetary environment resulting in lower interest outgo.

FY27 appears to be a transition year – moving from stability towards moderate growth. Rathi expects “fewer earnings downgrades and more results that are in line with or slightly above expectations. Overall, corporate earnings growth is likely to be in the range of 13-15 per cent, with a more realistic expectation closer to 13-14 per cent. This is not a runaway growth phase, but it represents a healthier and more sustainable earnings environment compared to the volatility seen earlier.”

“Over time, once earnings visibility improves and valuations normalise, the broader market tends to catch up,” says Bhandari of Monarch Networth Capital.

Corporate earnings have the potential to rise by 13 to 15 per cent in FY27. “This can provide fundamental support to a moderate rally in the market. Unlike DIIs, FIIs have the option to invest in global markets. Their investment will be guided by valuations, earnings growth and momentum. Indian valuations are even now higher than those of most markets, and earnings growth was tepid in FY25. Also, 2025 was largely an AI trade in which India couldn’t participate, since we do not have AI companies,” says Vijayakumar, hopeful that when corporate earnings improve, hopefully in FY27, the market will respond positively.

Getting the retail back

“Retail investors are the backbone of the market – ignoring them can be structurally damaging,” says Pachisia, echoing market sentiment. “Stronger earnings growth (already expected to rebound), valuation normalisation (premium to EM/China coming down), positive Budget cues (tax clarity), besides global factors like US growth softening, rate cuts, or AI hype moderating – freeing capital for EMs like India. India’s underweight position in FII portfolios (ownership down to 16 per cent) means CY26 selling should moderate,” summarises Shah.

Overall, 2026 looks better than 2025 for equities: earnings improving, valuations resetting, FIIs underweight (with room to come back), and policy tailwinds. “But stay disciplined: focus on quality, long-term compounding, asset allocation. Do not chase returns – patience wins, like Dhoni’s cool captaincy. Markets reward those who stay on the pitch,” concludes Shah.