India's headline equity index, the Nifty 50, presents a picture of robust health, trading merely 2% below its 52-week high. However, a starkly contrasting narrative is unfolding beneath this surface buoyancy. The Nifty Smallcap 250 index remains significantly adrift, nearly 12% away from its own peak, highlighting a pronounced two-speed market that raises critical questions about investor risk appetite and market breadth.
The Stark Divergence in Market Breadth
Data reveals a deeply uneven landscape. Within the Nifty Smallcap 250, a mere 10 stocks are within 0.5% to 9.9% of their yearly highs. On the other hand, a overwhelming majority are struggling: 131 stocks have declined between 10% and 30%, and another 90 have suffered even steeper falls of 31% to as much as 69%. This imbalance underscores a market where large-cap strength is not translating into broad-based gains.
The core question emerging from this split is whether investors have undergone a fundamental, structural shift away from riskier smallcap stocks. Most market participants, however, believe the current underperformance is cyclical. They attribute it to a combination of liquidity pressures, sustained foreign selling, and global macroeconomic uncertainty rather than a permanent change in preference.
Liquidity and Global Shocks Hit Smallcaps Harder
Vinay Jaising, Chief Investment Officer at ASK Private Wealth, explains the mechanics. He points out that while Foreign Institutional Investor (FII) ownership in smallcaps is around 9% (compared to roughly 20% in largecaps), their selling has a magnified impact due to lower trading volumes. FIIs have been net sellers to the tune of about $2 billion in December 2025 alone and nearly $18 billion for the calendar year so far, directly contributing to smallcap underperformance.
Jaising adds that smallcaps are inherently more sensitive to global shocks, such as a 6-7% appreciation of the US dollar against the Indian rupee or the threat of punitive US trade tariffs. Paradoxically, he views the current phase as an opportunity. From a multi-year perspective, the BSE Smallcap 250 index, despite an approximate 9% fall in 2025 and over 15% underperformance versus largecaps, remains the second-best performing equity cohort over five years, delivering a 24% compound annual growth rate.
Valuations and a Shift Towards Selective Investing
Valuation gaps further explain the divergence. The Nifty 50 trades at 23.9 times earnings, aligning with its five-year average. The Nifty Midcap 100, at 34.9 times, is slightly below its average. In sharp contrast, the Nifty Smallcap 250 is valued at 30.8 times earnings, which is notably above its five-year average of 27.9 times, indicating a premium that investors are now scrutinizing.
This scrutiny is leading to more selective investment behaviour. Vipul Bhowar of Waterfield Advisors notes that smallcaps offer mixed alpha potential currently. While they historically outperform in bull runs, elevated valuations and recent weak performance are pressuring them. He believes stronger quarterly earnings, a focus on quality companies with reasonable PEG ratios, and improved global risk appetite could lure long-term investors back.
Vipin Singhal of Anand Rathi Investment Banking observes a clear behavioural shift. For months, institutional capital has been chasing size and value. Investor appetite for small-cap IPOs has become "noticeably more selective rather than risk-averse in absolute terms," influenced by high valuations and moderated secondary market sentiment. He sees this as a cyclical phase with a sharper focus on quality, where family offices are increasingly diversifying into early-stage private investments for patient capital.
Echoing the cyclical view, Sunny Agrawal of SBI Securities states the market is now in a definitive bottom-up, stock-picker's phase. Investor interest is expected to return to select mid- and small-cap stocks that demonstrate sustainable, profitable growth at reasonable valuations, once there is a further reset in prices and an improvement in earnings visibility and market breadth.
