Who’ll win the next round—large-caps or mid- and small-caps?

Mid-cap and small-cap stocks have seen the greatest valuation expansion with the lowest earnings growth. If Q1 FY25 earnings fail to justify these valuations, a correction may be seen.

Large-cap stocks have shown the strongest alignment between price gains and earnings growth over the past year, while mid and small-cap indices, despite recent strong returns, have relied heavily on PE re-ratings rather than actual earnings improvements.

This divergence has raised concerns about potential corrections in mid and small-caps, making large-caps a safer bet for investors.

The Nifty Microcap 250, Midcap 150, NIFTY 100, and Smallcap 250 indices all posted positive returns in the last one month, with the microcap index leading at 6 percent. This strong performance among mid and small-cap stocks occurred despite minimal upgrades in aggregate earnings.

Fisdom Research highlighted that about 70 percent of the returns in these indices over the past year stemmed from PE re-rating rather than actual earnings growth.

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This suggests that stock prices have surged beyond their fundamentals, driven more by investor enthusiasm than by real earnings improvements. Even stocks with downgraded earnings have seen significant PE re-ratings, raising concerns about potential valuation contractions if earnings growth slows or investment inflows diminish.

Over the past year, the large-cap index has shown the highest EPS growth, with prices aligning closely with earnings. This indicates that while price gains have been modest, strong earnings growth could drive future valuation expansion.

In contrast, mid-cap and small-cap stocks have seen the greatest valuation expansion with the lowest earnings growth. If Q1 FY25 earnings fail to justify these valuations, a correction may be seen.

"Investors should be cautious, as the heavy reliance on re-rating without corresponding earnings growth makes these stocks particularly susceptible to corrections, especially if market sentiment shifts or economic conditions change," Fisdom said, adding that investors should focus on quality large-cap stocks to balance risk while still participating in growth opportunities.