The month of February was a tough one for the Indian stock markets, with significant cuts across the board in both large-cap indices as well as small and mid-caps. While the initial reaction to the Union Budget was positive—given the significant tax break provided to the middle class, which is expected to boost consumption next year, along with a revival in capital expenditure based on the spending forecasts given for the financial year 2025-26—this optimism was soon overshadowed by rapid declines. These declines were primarily driven by relentless foreign investor selling, which over the last six months has now crossed ₹2,50,000 crores, a record of sorts.
February ended with the Nifty declining by 5.88%, while the small- and mid-cap indices dropped by around 11% each. Interestingly, the Indian markets have diverged from most global markets, including major emerging markets, in the current downturn—an unusual phenomenon rarely observed in the past two decades. Only a few Southeast Asian markets, such as Indonesia, Thailand, and the Philippines, have witnessed a similar kind of fall.
With the market correction over the last few months, the one-year returns of the Nifty have flattened, while small- and mid-cap indices have slipped into negative territory. A lot of the blame for both the market fall and foreign investor outflows has been placed on interest rate differentials and a declining rupee. However, in my view, this is a flawed argument. In a similar scenario in the second half of 2023, when U.S. bond yields were actually rising and interest rate differentials between U.S. and Indian bonds were comparable, we saw foreign investors pour ₹1,50,000 crores into Indian markets.
The sharp rise in small- and mid-cap valuations, combined with the frenzy in IPOs and the exorbitant valuations of companies going public, was bound to have an impact on the markets. I had highlighted this concern in mid-2024, stating that the rally was unsustainable and predicting an 8-10% market decline, along with a cooling-off period for the small- and mid-cap frenzy and a slowdown in IPOs. Otherwise, the fall could have been even more drastic. However, as speculative activity persisted, valuations moved significantly above long-term averages, making the eventual correction even sharper. While I expected about 60% of the fall, the last leg of the decline has taken me by surprise as well.
Factors Affecting the Market in 2024-25
The year 2024-25 was marked by several disruptions that slowed down India’s economic momentum. It began with the general elections, which effectively froze activity from March to June 2024. This was followed by a severe heatwave and subsequent state elections. Additionally, extremely tight liquidity in the banking system—largely due to the RBI’s efforts to stabilize the rupee by selling dollars and buying rupees—led to a liquidity squeeze. This, coupled with the lasting effects of high inflation on consumer spending and a sudden halt in government capital expenditure (which had been growing rapidly in previous years), significantly impacted many companies and sectors.
However, many of these factors are unlikely to persist in the next financial year. The new RBI governor has already taken measures to improve systemic liquidity, the rupee is now being allowed to float, and the government is expected to resume strong spending. Furthermore, there will be no election-related disruptions, and tax breaks for middle-income earners will likely boost consumer spending, especially as inflation remains moderate. The RBI’s anticipated rate-cutting cycle will also support growth, albeit with a lag, by reducing interest costs for borrowers and improving corporate earnings.
The Global Tariff Wars and Their Impact
A major talking point contributing to market volatility is the ongoing tariff wars that have intensified following President Trump’s return to office. Constant news about tariffs and their impact on global growth creates uncertainty for both consumers and businesses. However, India remains relatively insulated from this issue, given that its trade surplus with the U.S. is modest at around $35 billion. Nonetheless, the persistent news flow around tariffs continues to create volatility in the markets.
At the start of the year, two key concerns were driving the negative outlook on emerging markets. The first was the continued rise in the U.S. Dollar Index, which has actually reversed in 2025, with the dollar losing value despite a brief recovery following tariff-related news involving Mexico and Canada. The second was the rise in U.S. bond yields, which made U.S. risk-free investments more attractive. However, bond yields have declined significantly in recent weeks, easing this concern.
Evaluating Indian Market Valuations and Global Positioning
At the end of February, Nifty’s one-year forward price-to-earnings (P/E) ratio had moderated to around 18.5x. The correction in small- and mid-cap valuations has been even more severe, with both indices down about 25% from their peaks. A lot of the speculative excess has now been flushed out, and market sentiment appears to be extremely oversold. While it is difficult to predict when foreign investor flows will reverse, long-term investors should focus on valuations. Across the large-cap universe, as well as in key segments of mid-caps, valuations now appear quite reasonable.
In my view, the significant tariffs imposed by the U.S. on major trading partners will eventually slow down U.S. economic growth, which, in turn, should lead to a decline in the U.S. dollar and bond yields. Additionally, the fiscal deficit reduction measures being discussed by the new administration could further dampen consumer demand and growth. This comes at a time when the U.S. market capitalization has surged to 70% of global market capitalization—up from just 30% a few years ago. As markets chase performance, distortions occur on both bullish and bearish sides, but mean reversion is inevitable, and we should see it play out sooner rather than later.
Looking Ahead
There are two major opposing forces at play globally. On one hand, the Trump administration is pushing to end two major wars, which could reduce geopolitical tensions. On the other hand, the ongoing tariff disputes are a source of continued uncertainty.
Overall, the current pessimism in Indian markets appears overdone, as investors are pricing in an excessively negative growth scenario for the next two years. However, macroeconomic indicators suggest a recovery, with both fiscal and monetary policies becoming more growth-oriented. Given that earnings growth will likely be much stronger than in recent years, and considering that stock market valuations are now below historical averages, the risk-reward balance appears highly favorable.
Unless one expects a financial crisis on the scale of 2008, history suggests that investing during significant market corrections—when large-cap indices are down 15-20% and small- and mid-caps are down 25-30%—has always been a profitable strategy in the long run. The reality is that higher-than-normal returns in equities are made when stocks are bought during periods of extreme pessimism and sharp corrections. That is precisely the scenario we are witnessing today. When there is blood on the street, it is usually time to buy.