IT stocks faced renewed selling pressure on Monday as traders built fresh bearish derivative positions ahead of the Q3 earnings season. The NSE IT index closed down 1.4%, with nine out of ten stocks declining between 0.4% and 2.2%. The sector-wide selloff was driven by cautious sentiment ahead of earnings and recent brokerage downgrades.

Stock Performance and Derivative Activity

LTIMindtree was the sole gainer in the IT pack, rising 0.13%, while the rest of the sector witnessed broad-based declines. Market analysts noted significant short buildup across major IT stocks, indicating trader pessimism ahead of quarterly results.

Heavyweights including TCS, Infosys, Wipro, HCL Technologies, and Tech Mahindra all added 3% to 6% of open interest as short buildup, while mid-cap IT stocks like LTIMindtree and KPIT Technologies saw around 10% addition in short positions.

Brokerage Downgrades Weigh on Sentiment

Recent brokerage actions contributed significantly to the negative sentiment. CLSA downgraded HCL Technologies and Tech Mahindra, while maintaining a cautious outlook on the sector's recovery prospects. The brokerage expects substantial upside for Persistent Systems, Coforge, and LTIMindtree due to stronger earnings growth, but remains selective on large-cap stocks.

Citi Research continues to expect a slow and uneven recovery for the sector, noting that valuations remain unattractive and recovery pace will be crucial.

Q3 Seasonality and Tariff Concerns

The third quarter is traditionally a softer period for IT companies due to several seasonal factors. Market participants cited fewer working days, seasonally higher furloughs, slower deal conversions, and delayed budget renewals by clients as key concerns for Q3 performance.

Additionally, fresh tariff concerns emerged after comments from US President Donald Trump regarding potential implementation of additional tariffs on India, raising worries about potential impact on the IT sector.

Mixed Performance Trends

Despite Monday's decline, IT stocks have shown contrasting performance across different timeframes. The sector has been underperforming over the past year but showed recovery in recent months as investors found value after the prolonged underperformance.

Analysts remain cautious about the near-term outlook, recommending exposure only for long-term investors while tracking management commentary and AI investment plans to assess the sector's future prospects.

The Indian IT sector appears to have weathered the worst of its challenges, with recovery expected by 2026 as artificial intelligence services gain wider traction, according to Abhishek Pathak, IT & Tech Analyst at Motilal Oswal Financial Services.

Recovery Timeline and Catalysts

While the upcoming third quarter is expected to be a non-event due to seasonal weakness and furloughs, Pathak maintains a positive outlook for the sector over a two to three-year horizon. The catalyst for turnaround will be the resurgence of short-cycle deals, particularly in AI implementation.

"We think a leading indicator of IT recovery will be short-cycle deals sort of coming back, and these short-cycle deals will largely be AI implementation deals where enterprises will move from pilots to serious implementation," Pathak stated. He anticipates this shift to begin from mid-2026, highlighting the importance of monitoring partnership agreements between Indian IT firms and major AI developers like Anthropic and OpenAI.

Market Dynamics and Investment Strategy

On the debate between mid-caps and large-caps, Pathak noted that while mid-caps have historically held the upper hand over the last five years, large-cap stocks now offer selective value opportunities. Companies with strong infrastructure management services and data practices might initially outperform those heavily reliant on application development, which could face challenges from AI-driven productivity gains.

Stock Recommendations and Upgrades

Motilal Oswal's top picks reflect a balanced approach across market capitalizations:

Valuation and Growth Outlook

Addressing concerns about HCL Technologies' valuation premium, Pathak argued that in the current unique business cycle without a clear bellwether, any company that consistently outperforms its peers has a right to be valued at a premium. "If they maintain their growth momentum, I think the valuation premium can be justified," he noted, though acknowledging margin concerns.

Regarding Coforge's recent acquisition worth $2.50 billion, Pathak viewed it positively from a capability standpoint, despite the price being slightly expensive. "The asset is good. The only concern from our end is the potential dilution that may happen going forward in the next one year," he cautioned.