1. Elevated Valuations After Outperforming For Years

Over the last few years, mid-cap and small-cap stocks have experienced substantial gains, pushing their elevated valuations towards corrections.

Nifty Smallcap 100 Index and Nifty Midcap 100 index were trading at significantly higher P/E ratios compared to Nifty 50.

The small and mid-cap stocks outperformed large-caps during the entire 2023-24. Many institutional and retail investors started booking profits, fearing correction due to overvaluation, triggering a chain reaction of selling.

2. Union Budget 2025-26 Fueling Further Uncertainty

Even though there was a 0.41% rise in the Nifty Smallcap 100 and the broader market showed mixed reactions, the Nifty Midcap 100 fell by 0.42%.

For investors, the union budget 2025-26 falls short of their expectations. There were no steps taken to reduce capital gain tax, leading this disappointment to translate into market corrections, volatility, and repelling foreign investment.

However, small and mid-cap companies in consumption-driven industries benefited from the tax relief measures as they increased disposable income.

On the other hand, small and mid-cap companies in infrastructure and other related industries witnessed a decline.

3. Sustained FII Selling With Rupee Depreciation

Amidst the global uncertainty, Foreign Institutional Investors (FIIs) have been consistently selling, making their exits from the Indian market.

In fact, in January 2025, FII sold $9 billion worth of Indian equities, marking it the second-highest monthly outflow on record.

This led to the depreciation of the Indian Rupee to near-record lows, hurting India’s import and trade deficiency.

The stronger US Dollar and ongoing global concerns further weakened investor confidence.

4. Lower Corporate Earnings And Declining Sectors

Another propellant towards this crash was the weaker-than-expected Q3 FY25 earnings reported by many mid and small-cap companies.

These disappointing earning reports dampened the investor's confidence, leading to sell-offs.

Investors no longer see promising growth projections for the future, which turns them into panic sellers.

Even the high-performing sectors earlier, which had fueled the previous growing rally, saw a decline in their profit margins due to a slowdown in global demand.

5. Domestic Monetary Policy & Liquidity Crunch

On February 7, 2025, the Reserve Bank Of India (RBI) announced an increase in the repo rate cut aimed at supporting the stock market stability and growth.

However, investors were expecting a larger rate cut, leading to disappointment and a temporary sell-off in riskier assets like small and mid-cap stocks.

Investors no longer see promising growth projections for the future, which turns them into panic sellers.

Since liquidity tightening measures by RBI curbed cash availability, it also affected the smaller companies relying on credit.

Such elevated interest rates made fixed-income investments such as fixed deposits and bonds more attractive to paranoid investors than equities.

6. Global Macroeconomics Concerns And Policy Decisions

The current geopolitical tensions in the Middle East hiked crude oil prices, burdening India’s import bill and increasing market volatility.

New U.S. tariffs on China, Mexico and Canada have only added to the global economic uncertainty.

In fact, this proves to be the first event in the causation chain that is making foreign investors risk-averse, pulling out their investment from riskier segments like small-cap and mid-cap in the Indian market.