The catalysts behind small cap outperformance

In 2025, small-cap stocks ended large caps’ decade-plus run of dominant performance, and the shift has carried over into 2026. Since the market lows following Liberation Day in early April 2025, the Russell 2000 Index has outperformed the S&P 500^® Index by roughly 14%, and it remains ahead by about 7% year to date.¹

The move has drawn less attention than it might have, given how much focus has gone to artificial intelligence (AI) and the mega-cap companies driving the capital spending cycle. Nonetheless, after roughly 14 years in large caps’ shadow, small caps have quietly turned a corner.

An extreme valuation disconnect helped create the conditions for the reversal, and since then the fundamental backdrop has continued to build. In our view, the combination of an attractive valuation starting point, improving earnings, and a supportive economic backdrop suggests this cycle may have staying power.

Discounted entry points still available

Despite the rally, we do not believe investors have missed the opportunity. Small caps had become exceptionally inexpensive relative to large cap over a roughly four-year period leading up to April 2025, trading among the cheapest 5% of relative valuation observations in decades of data. That gap has narrowed, but it hasn’t closed. On a forward price-to-earnings basis, the relative valuation still sits at a historically appealing level (Exhibit 1).

Earnings catch up

Valuation alone rarely sustains a multiyear cycle. What has changed is earnings: Second-quarter 2026 earnings per share for the Russell 2000 grew roughly 43%, well ahead of expectations near 26%, and about two-thirds of companies beat on both revenue and earnings estimates. Trailing 12-month earnings for the index also reached a new high.²

The S&P 500 also posted one of its best cap-weighted earnings seasons on record, but that strength was concentrated at the top: The median company in the index grew earnings at only about a quarter (13.8%) of the cap-weighted index pace (53%).³

Small-cap strength, by contrast, has been broad. Financials have benefited from a steeper yield curve, industrials from AI-related infrastructure spending and a manufacturing recovery, semiconductors from that same buildout, and healthcare from robust demand growth.

This breadth suggests the small-cap recovery is not dependent on a single industry. It also distinguishes the current environment from earlier periods when small caps appeared inexpensive but lacked the earnings growth needed to close the valuation gap.

Current estimates suggest small-cap earnings could grow faster than large-cap earnings in 2027 (21.8% vs. 10.6%, respectively).⁴ If that occurs, investors would have two potential drivers of return: earnings growth and additional valuation normalization.

AI is also a small-cap catalyst

AI is often viewed primarily as a large-cap opportunity, but small companies are participating too. Many industrial and technology businesses supply the equipment, components, and services required for data centers and other AI infrastructure. These “picks and shovels” companies are collecting revenue today as large tech firms build out capacity.

A separate, longer-term catalyst is small caps’ role as second-order AI beneficiaries. As AI tools become more broadly deployed across the economy, they could bring productivity gains and margin expansion for companies of all sizes. Because small caps generally start from a lower operating margin base, the same amount of margin expansion can translate into a much larger percentage increase in earnings. For example, a 200 basis-point margin expansion delivers roughly 33% earnings growth for a company with 6% operating margins, but only about 10% for a company with 20% operating margins.

Myth: Small caps need low rates to outperform

One of the most persistent misconceptions about small caps is that they require very low interest rates to outperform. History suggests otherwise.

Two of the strongest periods for small-cap relative performance over the past several decades occurred during the 1970s and the first decade of the 2000s. Both featured higher interest rates and persistent inflationary pressures.

We believe this partly reflects pricing and operating leverage. In a low-inflation environment, small companies may struggle to raise prices because they generally have less pricing power than large companies. When inflation is more widespread, businesses of all sizes are better able to adjust prices to cover rising costs.

That can have an outsized effect on small-company earnings. Small caps typically begin with operating margins in the single digits, while large-cap margins are often much higher. As a result, even modest margin improvement can produce a much larger percentage increase in small-cap earnings.

Current inflationary pressures may prove persistent. Tariffs, labor supply constraints, and the gradual fracturing of globalization could keep costs and rates elevated for years, regardless of which party holds office. In a potentially higher-for-longer interest rate environment, we favor companies with strong cash flow generation, solid balance sheets, and the ability to internally fund growth – characteristics that can provide resilience if financing conditions remain tight.

A new phase for small caps

For more than a decade, large-cap performance gave investors a good reason to concentrate their exposure up the capitalization spectrum, leaving portfolios more underweight small caps than most probably intended. These performance cycles tend to run long, often eight to 14 years. With earnings breadth improving and valuations still attractive, we believe the emerging small-cap cycle has room to run and gives investors reason to revisit that positioning.

IMPORTANT INFORMATION

Artificial intelligence (“AI”) focused companies, including those that develop or utilize AI technologies, may face rapid product obsolescence, intense competition, and increased regulatory scrutiny. These companies often rely heavily on intellectual property, invest significantly in research and development, and depend on maintaining and growing consumer demand. Their securities may be more volatile than those of companies offering more established technologies and may be affected by risks tied to the use of AI in business operations, including legal liability or reputational harm.

Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.