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Nifty and small and mid-cap stocks have rallied between 12% and 20% over the last few months, despite earnings downgrades and a slowing economy, creating a sharp disconnect between valuations and growth. In the recently concluded June quarter earnings for FY26, Nifty50 EPS grew 9.5% YoY, as against JM Financial's expectation of 10.3% YoY. As a result, the brokerage lowered its Nifty50 EPS estimates for FY26E and FY27E by 1.3% and 0.7%, respectively. Further, the proportion of misses was highest in small-caps, followed by large-caps, and then mid-caps. Specifically, 43% of small-cap companies missed expectations, compared to 28% in midcaps and 29% in large caps, said the brokerage. Nifty 500 index median PE ratio stands at ~41x, while median earnings growth is just 9% YoY. This imbalance is unsustainable and tilts the risk-reward in favour of sellers, said DSP Mutual Fund. It added that small-cap and mid-cap stocks, with high valuations and high earnings expectations, appear more exposed. But why is it that despite the mismatch between earnings and growth, the Indian stock market remains firm? The answer lies in liquidity. Liquidity - The real Indian stock market driver The Indian market continues to be largely disconnected from fundamentals, opined Kotak Institutional Equities. High valuations across sectors and companies are being supported by the price-agnostic purchases of retail investors. "In our view, the market is buoyed by the strong sentiment among retail investors, who are, in turn, appear to be enthralled by the market, notwithstanding rich valuations of the market, earnings downgrades and poor 12-month trailing returns," the brokerage said. Analysts believe that while investors cannot entirely ignore the disconnect between valuations and corporate earnings growth, which aren't currently favourable, the broader market may not fall sharply because domestic institutions have now become dominant shareholders. In July 2025, equity mutual funds (ex-arbitrage) saw inflows of ₹56500 crore, 80% higher MoM. This follows a 30% MoM rise in inflows in June 2025. Outstanding SIP accounts in the country stand at 94.5 million as of last month, 2.6 million higher than in June. The number of new SIPs registered (gross) increased by 0.7 million to 6.9 million in July, signalling unfazed retail participation. "Domestic institutional investors are currently sitting on a large cash pile of around ₹1.97 lakh crore, and the inflows continue. With over ₹28,000 crore coming in each month through SIP (Systematic Investment Plan) routes, this money needs to be deployed effectively," said Dr VK Vijayakumar, Chief Investment Strategist, Geojit Investments. This consistent inflow of funds is likely to prevent a deeper market correction, even though - from a valuation and sustainability perspective - a correction appears warranted, he said. However, such a correction may not materialise, he believes, especially if the proposed secondary tariff on India is either postponed or does not take place. In such a scenario, the market may continue to hold or even move higher despite stretched valuations, Vijayakumar added. Hopes of secondary tariff pause lend bulls support In an interview, US President Donald Trump over the weekend said that he would consider the question of the penalty tariffs on Russian oil in "two or three weeks", possibly indicating the August 27 deadline could pass for India without the implementation of punitive 25% tariffs over and above the 25% reciprocal tariffs. G Chokkalingam, Founder, Equionomics Research, said there's still hope that Trump may not be too aggressive toward India. From a geopolitical standpoint, antagonising India could be a strategic loss for the US, he said, adding that Russia, China, and India together represent nearly half the global population - antagonising India could tilt global power balances. So I believe the US will eventually compromise, and that is another factor that could hold markets from any major drawdown. Domestic fundamentals hold strong Additionally, analysts believe that on the domestic front, fundamentals are strong - S&P upgrade, surplus monsoon and lower crude oil prices. "S&P upgraded India's GDP outlook to over 6.3%. Monsoon is in surplus - 92% of the 36 subdivisions have received normal to excess rainfall. Crude oil is down 20% from its 52-week high and may fall further, especially with more supply expected in September. Lower oil prices reduce inflation, increase liquidity, reduce dollar outflow, and benefit many companies that use oil derivatives," Chokkalingam. Additionally, the government has recently announced a likely GST rate cut ahead of the Diwali season, which could spur demand. "For the last three years, despite good monsoons, rural and urban demand haven't been robust. The GST reform will help, although there will be a lag effect. I expect a boost to corporate earnings starting in the October-December quarter (Q3)," Equionomics Research's Chokkalingam said further. Sustainable market rally unlikely until... However, Vinit Bolinjkar, Head of Research at Ventura Securities, doesn't see GST reform offsetting the impact of the Trump tariffs on India. "I think the GST rate cut announcement - almost a halving of GST rates - is very structurally positive. Will it kick-start the domestic economy? Possibly. But will it help us offset the losses from the tariffs to a large extent? Maybe not. Because with these tariffs kicking in, your sales are effectively zero now. At 25%, your goods are tough to penetrate. You wouldn't consider it, and it will translate into losses," Bolinjkar said. I think the market will realise this soon, and it will sell off once this rationality comes into play, he opined. Indian stock markets jumped over 1% on Monday, August 18, amid GST reform hopes. Even in trade today, the Indian stock market held firm. Vijayakumar, too, believes that while the policy initiatives from the Government on the GST front, with indications of next-generation reforms, have improved market sentiments significantly, the fundamentals (earnings growth) will take time to respond. "A sustained rally in the market will happen only when we have indications of earnings revival," he opined. Commenting on the earnings growth expectations, Atul Bhole, Senior Fund Manager, Kotak Mahindra AMC, said that while earnings growth has been disappointing for the past few quarters, the Q1FY26 pick-up in earnings has been better than expected and could gather further momentum in H2 with various measures announced by the government & RBI since the beginning of this year. He also added that India has historically traded at a premium to other emerging markets (EM) due to better growth & RoE profile of corporates as well as diversity & resilience of the economy. "In fact, due to last one year's significant underperformance relative to other EM, the Indian market's valuation premium has settled at long-term averages," Bhole said, dismissing valuation worries.