Indian Stock Market: Why 2026 Could Outperform 2025

After a year marked by global volatility and shifting investor sentiment, the Indian stock market is projected to fare better in 2026 than it did in 2025. Several factors contributed to a somewhat muted performance in 2025, which analysts believe are poised to reverse course.

Looking back, 2025 began on a cautiously optimistic note. This tempered enthusiasm stemmed from substantial selling by Foreign Institutional Investors (FIIs) in the preceding months, coupled with high market valuations, reduced corporate earnings forecasts due to softened demand, and limited capital expenditure from both government and private sectors. Countering this, a robust domestic economy, anticipated reductions in interest and inflation rates, and a generally stable global economic climate offered some encouragement. As the year progressed, however, escalating global trade tensions, particularly the extension of a "tariff war" that negatively impacted India's trade status, dampened initial hopes. Geopolitical risks, such as the Israel-Hamas conflict, further fueled uncertainty, driving investors towards safe-haven assets like gold and silver. A significant shift occurred as FIIs adopted a strategy of selling Indian assets in favor of Chinese investments.

Despite these headwinds, India's large-cap stocks still managed to deliver a respectable 10% return. Small-cap stocks, on the other hand, underperformed significantly. This was largely attributed to declining domestic earnings growth resulting from reduced demand and elevated valuations. The substantial FII selling further strained market liquidity, disproportionately affecting smaller companies. While Domestic Institutional Investors (DIIs) provided some liquidity, their focus remained primarily on large-cap stocks. Retail investors, reacting to the market's struggles and drawn to the IPO market, largely engaged in profit-booking or selling at a loss during the latter part of the year. Even after price corrections, valuations remained high relative to the broader market.

Yet, 2026 presents a more promising picture. Analysts anticipate that many of the external risks that weighed on the market in 2025 will have subsided or even reversed. A key development is the expected signing of a trade agreement between India and the United States, potentially in two phases. While the immediate benefits might be delayed, this agreement is expected to strengthen the Indian Rupee, which has been under pressure due to a widening trade deficit.

Furthermore, Q2 corporate earnings have shown considerable improvement, and expectations for Q3 remain strong. This positive trend is expected to support the mid- and small-cap segments. While a selective performance is anticipated for these segments in 2026, long-term investors might find value in adopting an accumulation strategy with a 2-3 year horizon. In the medium term, large-cap stocks are expected to continue their strong performance. The broad market's performance may be selective, contingent on sustained earnings growth to justify current high valuations.

Looking ahead to 2026, key risks include the still-pending US-India trade deal, persistently high Federal Reserve interest rates, the ongoing Russia-Ukraine conflict, a potential reversal of the yen carry trade, and consistently elevated valuations. That said, the reality is a bit more complicated. the market has already absorbed much of the volatility associated with these risks. The US is actively engaged in trade negotiations with multiple countries, and midterm elections in November are expected to exert pressure on the government to curb inflation. Tariff reductions on various commodities are already underway to ease consumer price increases. The market is pricing in further rate cuts and a moderation of global risks in 2026, reflected in the India VIX volatility index dropping to a one-year low of 9.5x.

In 2025, FIIs were net sellers of Indian equities, offloading $17.6 billion year-to-date while increasing investments in other Asian markets like China and Japan. This was largely driven by India's high valuations, which have since normalized to below their long-term average, reducing FIIs' negative sentiment towards Indian assets. Even a shift from negative to neutral FII flows could significantly boost the Indian market, driven by domestic investment.

Based on this outlook, a revised investment strategy is recommended. For 2025, a multi-asset approach with 60% allocation to equity, 25% to debt, 10% to gold, and 5% to cash was suggested. The equity outlook is now upgraded to a multi-cap strategy, increasing the equity allocation to 85% (60% large-cap, 15% mid-cap, and 10% small-cap), while reducing debt to 10% and gold to 5%. A Nifty50 target of 29,150 is set for December 2026, representing a projected return of approximately 12%.

*Disclaimer: This analysis is for informational purposes only and should not be considered financial advice. Consult with a qualified financial advisor before making any investment decisions.*