Why are mid & small-cap stocks tumbling in 2025? Here are 5 key factors behind the decline

The year 2025 has begun on a turbulent note for investors in mid and small-cap stocks. The Nifty Midcap 150 index has tumbled by 7%, while the Nifty Smallcap 250 index has plunged by 9%. In stark contrast, the Nifty 50 has shown relative resilience, slipping only about 2%. This divergence underscores a significant shift in market dynamics, with investors gravitating towards the perceived safety of large-cap stocks amid growing uncertainties. A staggering 70% of small- and mid-cap stocks are currently trading below their 200-day moving averages, indicating sustained selling pressure.

What is driving this market correction?

The ongoing downturn in mid and small-cap stocks can be attributed to a combination of valuation concerns, macroeconomic challenges, and shifting investor preferences. Let’s break down the key reasons:

1. Overvaluation Following Years of Outperformance

Valuation Premiums: Over the past few years, mid and small-cap stocks experienced an extraordinary rally, pushing their valuations to unsustainable levels. The Nifty Midcap index’s next twelve-month (NTM) price-to-earnings (P/E) ratio is currently 58% higher than that of the Nifty 50, as reported by BNP Paribas Securities. While these premiums were once justified by strong earnings growth, the absence of fresh catalysts has left these stocks vulnerable to corrections.

Profit Booking: The sharp rally of 2023-24 saw many small- and mid-cap stocks significantly outperform their large-cap counterparts. As valuations peaked, investors—both retail and institutional—began booking profits, triggering widespread sell-offs. The resulting correction has further dampened sentiment, leading to fear-driven selling that has affected even fundamentally strong stocks.

2. RBI’s Hawkish Stance and Tightening Liquidity

While global central banks started cutting rates to stimulate economic growth, the Reserve Bank of India (RBI) up has maintained a cautious stance due to persistent inflation concerns. This has led to several challenges for mid and small-cap stocks:

Higher Borrowing Costs: Elevated interest rates have made financing more expensive, particularly for rate-sensitive sectors such as real estate, infrastructure, and MSMEs. Companies in these sectors are struggling to access affordable credit, leading to project delays and sluggish growth.

Shift to Fixed-Income Investments: With higher interest rates making fixed-income instruments such as bonds and fixed deposits more attractive, investors have shifted capital away from equities. This has resulted in lower liquidity inflows into mid and small-cap stocks, exacerbating their decline.

Liquidity Crunch: Rising bond yields have tightened monetary conditions, making it harder for businesses to secure capital. This has disproportionately affected high-beta stocks, which are more volatile and reliant on steady liquidity flows to sustain their valuations.

3. Sustained FII Selling and Rupee Depreciation

Foreign Institutional Investors (FIIs) have been net sellers in Indian equities amid global economic uncertainty and a strengthening US Dollar. This trend has had multiple consequences:

Pressure on the Indian Rupee: The rupee has depreciated significantly, hovering near record lows. This has increased India’s import bill and widened the trade deficit. Additionally, companies with foreign currency-denominated debt are facing higher costs, further straining profitability.

Diminished Attractiveness of Indian Markets: The US Federal Reserve’s tight monetary policy has driven capital flows towards developed markets, where investors are finding better risk-adjusted returns. Comparatively, emerging markets such as Indonesia and Vietnam, which have demonstrated stronger growth and currency stability, have become more attractive destinations for global capital.

While Domestic Institutional Investors (DIIs) have stepped in to counterbalance FII outflows—mainly driven by retail SIP (Systematic Investment Plan) investments—their buying has been insufficient to prevent broader market declines in the mid and small-cap segments.

4. Global Macroeconomic Pressures

High Crude Oil Prices: Geopolitical tensions in the Middle East have pushed crude oil prices higher, increasing India’s import costs and contributing to inflationary pressures. This has hurt industries that rely on fuel and petroleum-based inputs, such as transportation, chemicals, and logistics. Additionally, rising fuel costs reduce consumer disposable income, negatively impacting demand for discretionary goods.

Weak Global Demand: Export-oriented sectors such as IT, textiles, and industrials are facing headwinds due to slowing demand in key markets like the US and Europe. The US Federal Reserve’s restrictive monetary policy and ongoing economic uncertainty in Europe have led to reduced orders for Indian exporters. This, in turn, has affected domestic supply chains, amplifying the slowdown across multiple industries.

With global economic recovery remaining uneven, export-driven sectors are likely to continue facing challenges, adding to the overall bearish sentiment in the market.

5. Earnings Downgrades and Sector-Specific Weakness

Corporate earnings in several sectors have failed to meet expectations, leading to downward revisions in earnings estimates. Key areas of concern include:

Urban Consumption Slowdown: Inflationary pressures have squeezed disposable incomes, leading to reduced spending on discretionary goods. Consumer goods companies have reported weaker sales growth and declining profit margins.

Real Estate and MSMEs Under Pressure: Rising borrowing costs have dampened demand for housing in urban centres, while small finance banks catering to MSMEs are witnessing an increase in non-performing assets (NPAs) as borrowers struggle with repayment.

Export-Oriented Industries Struggling: IT services and textile exports have taken a hit due to weaker global demand. This has affected related industries such as logistics and transportation, creating a cascading effect on the broader economy.

While some sectors may recover in the medium to long term, the near-term outlook remains challenging as earnings growth remains subdued and inflationary concerns persist.

Is there more pain ahead?

Market experts believe that the correction in small and mid-cap stocks could persist until at least mid-2025, driven by global headwinds and domestic liquidity concerns. Several factors point to continued volatility:

Valuation Reset: As the correction progresses, valuations of mid and small-cap stocks are gradually realigning with fundamentals. While this may create long-term buying opportunities, the adjustment phase is not yet complete.

Sectoral Weakness: Key industries such as real estate, MSMEs, and consumer goods are still grappling with higher interest rates and inflationary pressures. Export-focused businesses remain vulnerable to slowing global demand, adding to the ongoing market weakness.

FII Outflows Likely to Continue: With the US Dollar strengthening and global bond yields remaining high, foreign investors are unlikely to return to Indian equities in the near term. This leaves the market heavily reliant on domestic investor participation to sustain stability.

However, history has shown that market corrections often pave the way for healthier and more sustainable growth. Long-term investors focusing on quality stocks in resilient sectors such as green energy, infrastructure, and affordable housing may find attractive opportunities as valuations normalize. Additionally, retail investors, supported by steady SIP inflows, are increasingly viewing these corrections as potential entry points, signaling a shift toward more disciplined, long-term investing.

Conclusion

The ongoing crash in mid and small-cap stocks highlights the inherent volatility in an overvalued market. Elevated valuations, macroeconomic challenges, and FII outflows have combined to create a challenging environment for investors. While the near-term outlook remains uncertain, disciplined investors focusing on quality and fundamentals will likely emerge stronger in the long run.

(The author is Cofounder & Executive Director, Prime Wealth Finserv Pvt. Ltd.)

Disclaimer: The views and recommendations above are those of individual analysts or broking companies, not Mint. We advise investors to check with certified experts before making any investment decisions.