Four reasons why small-cap stocks are lagging behind in the current market rally

The NIFTY50 hit a new record high after 14 months on November 27, having gained nearly 12% in 2025. After a nearly 6% rally in the last two months, Indian markets are back among the best-performing global markets. Along with NIFTY50, the NIFTY Midcap 100 also hit a new record high of 61,229. While large and midcap stocks are back in action, small-cap stocks are lagging behind in the current rally. They NIFTY Smallcap 100 is still down nearly 5% in 2025 and nearly 10% away from the previous record high level of 19,761.

Lofty valuations

The NIFTY Smallcap 100 index witnessed a steep correction in 2025 from the record high levels touched last year. The index made a record high in December 2024 and traded at 36.1 times the price-to-earnings ratio, which was significantly higher than the 3-year median average of 28x. However, even after one year, the index continues to trade much higher than its median valuation of 28x. The lofty valuations have kept the investors wary. Experts believe that strong earnings growth could ease the pressure on valuations and bring investor interest back into small-cap stocks.

Tepid earnings

Though the Q2FY26 earnings saw a strong recovery in performance across the board, small-cap earnings failed to excite investors optimism. As per reports, a majority of the NIFTY Smallcap 100 constituents failed to beat earnings expectations in the September 2025 quarter. At the consolidated level, the aggregate net profit growth for 90 companies in the NIFTY Smallcap 100 index stood at 1.5%, as compared to 7% to 8% growth in the NIFTY Midcap 100 and NIFTY50 for the same period. Lower earnings growth has kept the overall valuations of the small-cap index at elevated levels, making it unattractive for investors.

Lower FII and DII participation

Foreign institutional investors were net sellers in the Indian markets in September quarter, adding pressure to the small-cap stocks overall. Stocks like Amara Raja, MRPL, Swan Corp, Kajaria Ceramics, Neuland Laboratories, Cyient, Piramal Pharma, Crompton Greaves and a few others saw consistent selling by FIIs in the last four quarters. Further, mutual fund inflows into small-cap stocks slowed down in 2025. In contrast, mutual funds consistently added stakes in 25 midcap stocks in the past four quarters, as compared to 18 small-cap stocks.

Time correction

As the NIFTY50 and NIFTY Midcap indices regained momentum in 2025 with a steady rally to record high levels, small-cap stocks continued to witness a period of consolidation. After the sharp rally leading to euphoric valuations, the indices tend to go through a long period of consolidation before regaining the momentum. Similarly, the NIFTY Smallcap 100 has gone through time correction of nearly 12 months.

Previously, after recovering from the COVID-19 correction, the index recovered nearly 247% from March 2020 to November 2021 and witnessed a time correction of nearly 2 years till June 2023. The current technical charts show a similar setup of long consolidation before the next breakout.

In conclusion, small-cap stocks are expected to remain volatile due to their unpredictable earnings and performance. Further, they are known to be high-beta stocks, meaning in the overall sluggish period, they tend to underperform significantly than their large-cap and midcap peers. On the flip side, they also outperform the benchmark indices by a huge margin during euphoric times.