Indias smallcap index has recovered above pre-war levels following the US-Israel-Iran conflict, while the Nifty and midcaps still trade below their late-February peaks, highlighting a sharp market divergence. The smallcap gauge has surged 2.3% to 16,051.40, supported by strong domestic participation. The trend reflects shifting equity ownership patterns, though questions remain on whether the rally can sustain or broaden further.

Smallcap stocks have already erased Iran war losses. Is a bluechip breakout next?

India's smallcap index has fully recovered from the US-Israel-Iran conflict, surging past pre-war levels even as benchmark Nifty remains trapped below its late-February peak, raising questions about whether bluechips are now poised for a comeback or if the smallcap rally has further to run.

The smallcap gauge closed 2.3% higher Wednesday at 16,051.40, eclipsing its February 27 level of 15,881.05 recorded before the war erupted. Nifty, meanwhile, has yet to overtake the 25,178.65 mark seen that day despite an 8% April rebound from March's brutal 10% selloff. The midcap index also trades below pre-war levels.

The divergence reflects a structural shift in Indian equity ownership. Since January 2020, smallcaps have multiplied 2.9 times and midcaps 3.3 times versus just 2.0 times for Nifty 50, driven by heavier domestic participation in smaller stocks compared to foreign-dominated largecaps.

"Valuations are far more reasonable, and the risk-reward has turned favourable," said Chandraprakash Padiyar, senior fund manager at Tata Asset Management, announcing the reopening of lumpsum investments in the Tata Small Cap Fund after closing the window in June 2023. His fund has reshuffled 75-80% of its portfolio over 15-18 months, concentrating 70% in the top 30 holdings. "Market volatility and global geopolitical factors have led to a meaningful moderation in earnings expectations and a correction in valuations."

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Vinay Paharia, CIO at PGIM India Mutual Fund, echoed the bullish smallcap view: "Largecaps and Smallcaps are now trading very close to their longer term averages in terms of valuation and risk-reward is much more balanced than before." He called midcaps "moderately rich" and "less preferred" compared to the other two segments.

But not everyone is convinced that smallcaps offer the best risk-adjusted returns from here. Vinod Karki at ICICI Securities argued that the smallcap space “did not correct the way it typically does during such mega events,” noting that while the Nifty crashed 10-11%, smallcaps, normally higher-beta assets, failed to deliver the 15-20% index-level drawdowns usually seen in such crises.

“They are riskier assets compared to largecaps, and they have not corrected enough to offer mouthwatering valuations,” Karki said. “From a risk-reward basis, I would say the Nifty is much better.”

Dr. VK Vijayakumar, chief investment strategist at Geojit Investments, predicted that largecaps may stage a “smart comeback” in the near term but could face renewed pressure when foreign portfolio investors resume selling, potentially drawn to momentum in South Korean and Taiwanese markets. “Sustained resilience in the near term is likely to be in mid and smallcaps, which will not come under pressure from FPI selling.”

Axis Mutual Fund struck a cautious note, highlighting “valuation dispersion rather than uniformly attractive valuations.” While select cyclical, industrial and financial names now offer better entry points after the correction, “large parts of consumption- and investment-led sectors continue to trade at relatively elevated multiples, warranting selectivity rather than aggressive positioning.”

The debate underscores the market’s unsettled state: smallcaps have recovered the fastest, but whether that signals opportunity or overheating depends on which risk lens investors apply.

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