Equity mutual fund inflows had surged to nearly $2.4 billion (Rs 20,000 crore) per month, roughly four times the pre-demonetisation average, while smallcap stocks traded at valuation multiples approaching twice those of the Nifty 50.
Nearly a decade later, investors are asking remarkably similar questions, and the parallels with that period are difficult to ignore.
Back then, my analysis of nearly three decades of market data highlighted a powerful feedback loop between retail participation and market valuations. Domestic investors, including retail, tend to respond to realised returns rather than anticipated ones.
Rising stock prices attract more retail money, which in turn pushes valuations higher and generates further gains, creating a self-reinforcing cycle. However, foreign institutional investors (FIIs) play a different role.
While domestic flows can amplify momentum, sustained FII selling eventually exerts pressure on valuations and returns if it persists long enough.
My conclusion in 2017 was straightforward. As the extraordinary liquidity conditions normalised, interest rates increased, and FII selling continued, market returns would weaken, leading retail participation to fade. The sequence unfolded largely as expected.
As excess liquidity from demonetisation and GST-related disruptions dissipated, the froth in mid and smallcap stocks evaporated. In 2018, the Nifty Smallcap Index declined by 36%, the Nifty Midcap Index by 22%, compared with declines of 12% and 5% in the Nifty 500 and Nifty 50 respectively.
The Familiar Narrative
Many of the arguments being made today closely resemble those heard during the previous cycle.First, there is the assertion that FIIs no longer matter because domestic flows are sufficiently large to absorb any offshore selling pressure.
Second, there is a widespread belief that small and midcap companies are fundamentally different from large caps and deserve materially higher valuations because of superior growth prospects.
Third, investors continue to argue that non-bank financial companies can sustain strong earnings through robust credit growth and supportive interest rates.
Finally, there is the conviction that India's economy remains exceptionally resilient despite global challenges, with reported real GDP growth remaining above 8%.
What makes these claims particularly familiar is that similar arguments were prevalent in 2017. At that time, the economy appeared resilient even as crude oil prices subsequently climbed by nearly 60% and the US Federal Reserve was well into its policy normalisation cycle after years of near-zero interest rates.
Yet beneath the headline growth figures, economic conditions felt considerably weaker than official statistics suggested. I expressed reservations then about the divergence between reported GDP and underlying economic reality. Those concerns have only intensified today and are increasingly shared across investor circles.
The Key Difference: Retail Persistence
There is, however, one notable difference between the current cycle and 2017. Retail investor participation has proved significantly more durable.Historically, retail participation tended to weaken when market returns turned persistently negative. This time, retail investors have remained remarkably committed despite modest returns and persistent foreign selling.
Since the pandemic-induced market shock in April 2020, domestic investors, predominantly retail, have committed approximately $158 billion (Rs 13.2 lakh crore) to equity mutual funds.
The flow pattern can be divided into two distinct phases. Between April 2020 and September 2024, investors contributed $77 billion (Rs 6.4 lakh crore), averaging roughly $1.4 billion (Rs 11,900 crore) per month. The second phase, from October 2024 through July 2026, saw an even more dramatic acceleration.
During these 22 months, investors contributed $80 billion (Rs 6.7 lakh crore), averaging approximately $3.7 billion (Rs 30,600 crore) per month, more than double the pace of the earlier period.
Over the same timeframe, foreign investors have generally moved in the opposite direction. While strong inflows in FY21 and FY24 provided temporary support, cumulative FII selling in other years more than offset those purchases.
The result has been sustained foreign outflows despite an unprecedented surge in domestic participation.
This raises a crucial question: has the relationship between flows and returns fundamentally changed?
The evidence suggests otherwise. During the first phase of the pre-pandemic period, the Nifty 500 generated an extraordinary annualised return of nearly 33%.
During the second phase, despite significantly stronger retail inflows, annual returns turned negative at 5.5%. The Nifty 50 has also suffered a meaningful drawdown, declining sharply despite continued SIP participation and resilient mutual fund inflows.
In other words, domestic liquidity has remained abundant, but returns have deteriorated. That alone challenges the popular belief that domestic money, by itself, can indefinitely sustain market valuations.
More importantly, there is a risk that a prolonged period of negative returns could begin to weaken retail inflows, which are already showing early signs of fatigue.
Structural Challenges Are More Intense Today
If anything, the current environment is arguably more challenging than the one that prevailed before the 2018 correction.The headwinds confronting markets today are increasingly structural rather than cyclical. Global trade fragmentation, geopolitical instability, elevated commodity prices, and limited domestic policy flexibility have created a more difficult environment for both economic growth and corporate profitability.
Inflationary pressures remain persistent, particularly through higher input costs and energy prices.
The disconnect between headline macroeconomic data and ground-level business conditions is also becoming harder to ignore. Official GDP data continue to indicate robust growth in the range of 7.5-8.0%.
Yet household demand, informal sector surveys, domestic GST trends, and corporate commentary often paint a less optimistic picture. Rising input costs have compressed value addition, while domestic consumption remains uneven.
The market itself appears to be expressing skepticism. If the economy were genuinely delivering the strength implied by reported growth numbers, one would ordinarily expect stronger earnings momentum, expanding corporate investment and rising equity valuations. Instead, valuations have steadily compressed.
A Valuation Reset Rather Than a Temporary Correction
The recent weakness in equities appears to reflect a deeper reassessment of growth expectations rather than a temporary pullback driven by sentiment.Even after a powerful post-pandemic earnings recovery, valuation multiples have moved significantly lower. The Nifty 500 now trades around 21 times trailing earnings compared with an average near 30 times during the pre-pandemic levels. The Nifty 50 has experienced a similar derating.
This compression has occurred despite a period of exceptionally strong earnings growth between 2020 and 2024. The message from the market appears clear: investors increasingly believe the extraordinary post-pandemic earnings boom was temporary, and that the economy may now be transitioning toward a lower-growth equilibrium.
Sector performance reinforces this interpretation
Defensive sectors such as pharmaceuticals, PSU banks and metals have generally outperformed, while sectors linked more directly to discretionary spending and growth expectations, including IT, FMCG and real estate, have underperformed. Such leadership patterns are typically associated with caution rather than optimism.The slowdown in earnings growth further explains investor behaviour. While earnings expanded rapidly during the initial recovery period, growth has slowed dramatically since mid-2024. As profit growth moderates, markets naturally become less willing to pay premium valuation multiples.
What Would Change the Outlook?
For equities to resume a sustained upward trajectory, three conditions are likely required.First, corporate earnings need to demonstrate a genuine and broad-based acceleration rather than relying on cost-cutting measures to support profitability.
Second, the prevailing stagflationary backdrop must ease through moderation in geopolitical tensions, commodity prices and global economic uncertainty.
Third, global risk-free rates need to decline sufficiently to improve liquidity conditions and support valuation multiples.
At present, none of these conditions appears firmly in place. Earnings remain subdued, inflation risks persist and the geopolitical environment continues to create uncertainty for both growth and capital flows.
Positioning for the Next Phase
Against this backdrop, investors may need to shift their focus from momentum to quality.Many companies have been able to protect margins through cost optimisation, productivity improvements and tighter expense control. However, these strategies have finite limits.
Without stronger demand growth, sustaining profitability becomes increasingly difficult.
Large-cap companies appear relatively better positioned. Their stronger brands, superior distribution networks, easier access to capital and greater pricing power provide important advantages in a period of slowing growth and elevated costs.
While select smallcap companies with unique products or dominant niche franchises can continue to outperform, broad-based smallcap leadership appears unlikely.
Indeed, the past two years demonstrate that performance within the mid and smallcap universe has become increasingly stock-specific rather than driven by a rising tide lifting all boats. Earnings trends have failed to justify the enthusiasm implied by previous valuations.
The central lesson from 2017 remains highly relevant today. Liquidity-fuelled rallies endure only as long as realised returns reinforce investor confidence.
While retail participation has proven much more resilient this time, resilience should not be mistaken for sufficiency. Domestic flows can cushion markets, but they cannot permanently offset weak earnings, persistent foreign selling, elevated global interest rates and deteriorating macro fundamentals.
Until earnings growth reaccelerates, global headwinds ease and capital costs decline, the most likely path forward remains one of selective opportunities rather than a broad-based bull market. In such an environment, patience, quality and valuation discipline are likely to be rewarded far more than momentum chasing.
(Dhananjay Sinha is CEO & Co Head of Equities)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)
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