The Indian economy grew by 7.8% in 2025-26, up from 7.2% in the previous year. This strong momentum continued into the first quarter of 2026-27, with GDP growth holding at 7.8%, marking a four-year high for any first quarter. Growth remained strong despite uncertain global trade, and geopolitical tensions.

Banking credit growth accelerated from 11% in FY26 to around 18% recently. Meanwhile, banking asset quality hit a 10-year high. Adjusted net profits for NIFTY 500 companies grew by 15% year-on-year in FY26, and by 13% in Q1 FY27. Excluding the oil and gas sector, first quarter earnings jumped by 23%. Despite these strong fundamentals, the NIFTY index fell about 10% over the past year and 14% over the last two years.

Impact of Twin Liquidity Deficits
The current market weakness is driven by twin liquidity deficits in the secondary market, a phenomenon unseen in three decades. Foreign Portfolio Investors (FPIs) sold equities worth ₹1.7 trillion in 2025 and over ₹2.6 trillion so far in 2026. This selling was confined to the secondary market. In contrast, FPIs were net buyers in the primary market, investing over ₹540 billion in IPOs in 2026.

Rising global crude oil prices and a weaker rupee caused this tactical shift. FPIs chose short-term gains in IPOs over medium-to-long-term investments in listed stocks. Because FPIs focus heavily on NIFTY and Sensex stocks, their exit created severe liquidity constraints. This capital outflow explains why large-cap indices underperformed Small and Mid-cap indices.

Domestic retail investors also worsened secondary market liquidity by shifting their focus to IPOs. The primary market has absorbed ₹1.95 trillion in 2025 and ₹1.05 trillion so far in 2026. Over the last two years, an average of 700,000 new retail investors entered the market each week, bringing the total investor base to 265 million. Most of these new investors are chasing IPOs, rather than buying already listed stocks.

Historical Cycles and Valuations
Historically, since the first major IPO boom in the early 1990s, secondary market surges in small and mid-caps have triggered IPO booms. Usually, an IPO boom leads to a crash in listed small and mid-cap stocks. The secondary market typically recovers only after the IPO craze cools down. This time is unique because FPIs have joined retail investors in chasing short-term IPO gains at an unprecedented scale.

The valuation gap between new IPO stocks and listed small and mid-cap stocks is now widening. History suggests that retail investors will soon return to listed small and mid-cap stocks due to their attractive relative valuations. The current IPO momentum is set to slow down, which will ease liquidity for listed small and mid-cap stocks.

However, FPIs are unlikely to return to NIFTY and Sensex stocks unless crude oil prices fall sharply, and the rupee outlook improves. The Indian crude oil basket price has doubled from its 52-week low. Consequently, short-term outlook for large-cap stocks remains weak due to foreign capital constraints, allowing the small and mid-cap segment to outperform in the near term.

Market Outlook
The absolute valuations for the NIFTY and Sensex are still highly attractive compared to historical standards. The indices are trade at a steep discount to small and mid-cap indices. If the West Asian conflict eases, global oil prices will drop and the rupee will recover. This scenario could trigger a sharp rebound for the NIFTY and Sensex, potentially repeating the large-cap outperformance seen in 2018–2019. The Reserve Bank of India appears to share this optimism, considering it is holding on to an unprecedented gross short position on the US dollar of roughly $200 billion.