The year 2025 commenced for the Indian stock market on a note of wary optimism. This cautious sentiment was shaped by a confluence of domestic and international headwinds, including persistent selling by Foreign Institutional Investors (FIIs) in the final quarter of 2024, stretched market valuations, a moderation in corporate earnings due to softer demand, and sluggish capital expenditure from both government and private sectors.
Navigating Headwinds: Why 2025 Tested Investor Patience
However, the initial optimism faced significant erosion as the year unfolded. The primary catalyst was the escalation of the global "tariff war," which lasted longer than anticipated and resulted in India being moved to a less favorable tariff list with higher imposed rates. Concurrently, geopolitical risks expanded with the Israel-Hamas conflict. In this turbulent environment, traditional safe havens like gold and silver emerged as the best-performing assets.
The impact on India was pronounced, exacerbated by FIIs strategically pivoting to a 'sell India, buy China' approach. This shift led to substantial net selling, with FIIs offloading a massive $17.6 billion year-to-date (YTD). Despite these formidable challenges, India's large-cap segment demonstrated resilience, managing to deliver a respectable 10% return.
In stark contrast, small-cap stocks significantly underperformed. This divergence was driven by a double whammy: declining domestic earnings growth stemming from demand moderation and their persistently elevated premium valuations. The heavy FII selling drained overall market liquidity, a blow that disproportionately affected the more volatile small-cap space. While Domestic Institutional Investors (DIIs) provided counterbalancing liquidity, their focus remained largely on large-cap stocks.
Retail investors, facing persistent domestic market underperformance, began losing patience. Their activity in the latter half of the year was characterized by profit-taking or loss-booking, with attention shifting towards the bustling Initial Public Offering (IPO) market. A critical issue persisted: even after price corrections, valuations continued to trade at a premium compared to the broader market.
2026 Outlook: A Brighter Horizon with Selective Opportunities
Analysts project that 2026 is likely to be a better year for the Indian stock market than 2025. The reasoning is that many external risks have already been factored in and tested by the market. These headwinds are expected to gradually reverse. A key positive development on the horizon is the anticipated signing of a trade agreement between India and the United States in 2026. Although this pact is likely to be implemented in two phases, delaying immediate benefits, its resolution is expected to strengthen the Indian Rupee (INR), which has been under pressure from a widening trade deficit.
Fundamentally, corporate earnings have shown a healthier trend, with a much better performance in Q2 of the fiscal year and robust expectations for Q3. This improvement is poised to provide support to the mid- and small-cap segments. Consequently, selective performance is anticipated for mid and small-caps in 2026, and long-term investors might consider an accumulation strategy with a 2–3 year horizon. Nevertheless, large caps are expected to sustain their medium-term outperformance, while the broad market's gains will likely be selective, contingent on sustained earnings growth justifying high valuations.
Persisting Risks and a Revised Investment Strategy
As the year closes, key risks for 2026 remain, including the pending US-India trade deal, elevated US Federal Reserve rates, the ongoing Russia-Ukraine conflict, a potential reversal of the yen carry trade, and still-high valuations. However, the market's volatility in response to these risks has diminished, evidenced by the India VIX volatility index falling to a one-year low of 9.5.
Positive signs include the US government's likely pressure to curb inflation ahead of its midterm elections in November, potentially through tariff reductions on commodities. Markets are anticipating further interest rate cuts and a moderation of global risks in 2026. Furthermore, India's premium valuation, which triggered FII selling, has now normalized below its long-term average, reducing a major source of negativity. Even a neutralization of FII flows from negative to zero could significantly boost market performance, driven by strong domestic flows alone.
In light of this outlook, analysts have upgraded their investment strategy. For 2025, a multi-asset allocation was suggested (60% equity, 25% debt, 10% gold, 5% cash). For the coming period, the view on equity is upgraded to a multi-cap approach with an 85% equity allocation: 60% in large-cap, 15% in mid-cap, and 10% in small-cap stocks. Debt allocation is cut to 10% and gold to 5%. Within this framework, analysts hold a Nifty50 target of 29,150 for December 2026, implying a return of approximately 12%.
Disclaimer: This analysis is for educational purposes only. The views and recommendations are those of individual analysts or broking companies. Investors are advised to consult certified experts before making any investment decisions.
