Indian equity markets closed higher for the fourth straight session on Monday, extending gains across major indices. But beneath the bullish surface, the small-cap frenzy continues to spark debate: is this a sustainable rally, or a bubble forming in plain sight?
Headline Rally: 4 Days, All Green
Indian equity benchmarks continued their upward march for the fourth consecutive session on Monday, driven by broad-based buying and upbeat global sentiment.
The Sensex gained 256 points to close at 82,445 (+0.31%), while the Nifty 50 advanced 100 points to end at 25,103 (+0.40%). Strong buying was witnessed across key sectors such as PSU Banks, Oil & Gas, IT, and Financials, indicating renewed investor confidence. Realty was the only sector to end in the red.
Notably, mid- and small-cap indices outperformed, gaining 1.2% and 1.6% respectively, as retail flows continued to drive momentum in broader markets.
Small-Caps: Skyrocketing Valuations, Shrinking Profits
Amid the celebratory rally across the Indian markets, small-cap stocks are flashing serious warning signs. As of early June FY26, the Nifty Smallcap 250 has surged ~15%, even as aggregate profit after tax (PAT) for the segment fell by 16% YoY. In just the last two months, this euphoria has added a staggering ₹9 lakh crore to small-cap market capitalisation, without any earnings support.
Valuations have now ballooned to an eye-popping ~33x forward P/E, significantly above the historical average of ~19–20x, according to data from Bloomberg and Motilal Oswal. This dislocation between price and profitability has made small-caps the most expensive pocket of the Indian market. For comparison, large-caps currently trade near 20x, while mid-caps hover around 27–28x.
With earnings underwhelming and participation thinning, the small-cap surge appears increasingly liquidity-led, leaving risk-aware investors questioning if the rally is built on hope or hot air.
Retail Confidence vs Institutional Caution
The current rally reveals a stark divergence in sentiment between foreign institutional investors (FPIs) and domestic participants. As of 9 June 2025, FPIs have accumulated net short positions worth $2 billion in index futures, their largest bearish bet since February 2025, according to NSE derivatives data. This comes despite the Nifty 50 gaining nearly 4.5% over the past four sessions, signaling institutional skepticism about the rally’s sustainability.
In contrast, retail and high-net-worth individuals (HNIs) have built $1.54 billion worth of net long positions, reflecting optimism, but also a potential case of overconfidence.
The long-short ratio for FPIs has dipped below 0.4, indicating a decisively bearish stance, while for retail investors, it remains above 1.2, highlighting their continued bullish positioning. This split suggests the rally may be narrowly driven, with the potential for a sharp reversal if FPIs accelerate selling or if global triggers, such as Fed commentary or crude prices, turn adverse.
Global Sentiment: A Double-Edged Sword
Global cues have played a pivotal role in sustaining the current market optimism. The U.S. economy added 272,000 jobs in May 2025, far exceeding estimates of 180,000, indicating strong labor market resilience. This boosted hopes of a soft landing and kept risk assets globally, including Indian equities, in demand. Additionally, renewed U.S.- India trade discussions, particularly around digital trade and semiconductor partnerships, have lifted investor sentiment.
Meanwhile, tentative progress in U.S.- China trade negotiations, including discussions on tariff rollback and technology exports, has further improved global risk appetite.
However, the backdrop remains fragile. The U.S. CPI inflation print due next week and the upcoming Federal Reserve meeting on June 18 could trigger sharp reactions. A higher-than-expected inflation number or hawkish commentary could revive fears of further tightening. Moreover, ongoing geopolitical risks, especially in the Middle East and Taiwan Strait, could reverse capital flows abruptly. In short, global support remains helpful but conditional and volatile.
What Could Go Wrong?
Despite the euphoria, several red flags loom that could derail the current rally. The upcoming Q1 FY26 earnings season will be a critical litmus test, particularly for small-cap stocks. With aggregate FY25 small-cap PAT down 16% year-on-year, any further disappointment could trigger swift valuation corrections. Markets are currently pricing in a robust earnings rebound, but if reality falls short, the elevated 33× forward P/E could compress rapidly, eroding investor wealth.
On the liquidity front, the RBI’s recent repo rate cut, has supported sentiment. However, any signal of reversal whether due to rising inflation, external imbalances, or a hawkish Fed may pull the plug on this liquidity driven rally.
Globally, a correction in the U.S. tech-heavy Nasdaq, up nearly 18% YTD, or unexpected tightening in the June 18 Fed meeting could trigger risk-off flows. With FPIs already building large short positions, even a small global tremor may hit Indian markets hard.
All-in-All
The current market rally is undeniably strong, driven by domestic optimism and abundant liquidity—but it’s walking a tightrope. Small-cap valuations near 33x forward P/E, a widening earnings gap, and rising FPI short positions (~$2 billion) reveal underlying fragility. While there’s no immediate cause for panic, this is a prudent time to reassess risk. Investors should consider rebalancing portfolios, tightening stop-losses, and steering clear of momentum traps in overstretched segments. Riding the wave is fine—just don’t lose sight of the undertow.
