Why Smart Money Will Rotate to Small Caps in 2026

Small-cap stocks are trading at valuations we haven't seen since the dot-com era, creating what may be the most compelling risk-reward setup in US equities.

The market's attention has been captured by mega-cap technology stocks this year. 

The S&P 500 gained over 23% in 2024, with the so-called Mag7 stocks surging nearly 67%. 

But this concentration has created a historic anomaly. 

The Russell 2000 forward P/E ratio stands at 16, while the relative forward P/E of 0.72 vs large caps sits well below the historical norm of 0.99.

Small-cap forward P/E ratios currently measure 13.6 compared to 17.2 for the S&P 500, and the S&P 500 has outperformed the Russell 2000 by 130% over the past decade. This represents one of the widest spreads between large and small caps since the late 1990s.

The disconnect becomes clearer when examining market concentration. For the full year 2024, only 19% of stocks within the S&P 500 outperformed the index itself, signaling that mega-cap dominance has left the broader market behind.

In Q4 2024, the small-cap valuation premium declined as large caps continued to outpace small caps. But valuations rarely stay disconnected forever. 

Bank of America's regression models project that small caps could deliver 9% annualized returns over the next decade, substantially above the 1% forecast for large caps.

Small companies face different financial structures than their large-cap counterparts. Small-cap firms typically rely on short-term loans with interest rates tied closely to those set by the Federal Reserve. This means they're more sensitive to rate changes.

Small-cap companies are particularly advantaged by lower interest rates since they tend to rely more on credit for growth and often have floating-rate loans. With consensus forecasting three rate cuts in 2026, the financial burden on small-cap balance sheets should ease substantially.

BofA estimates that cumulative pressure from higher rates could reach 32% of Russell 2000 non-financial operating earnings over five years. 

Each 25 basis point cut reduces this impact by roughly 2 percentage points.

Historically, small caps tend to outperform in the year following the first Fed rate cut, especially during cycles tied to recessions. In approximately 60% of recession-linked easing cycles, small caps have beaten large caps.

Trade policy uncertainty has become a recurring theme in markets. But small-cap companies have built-in protection that large multinationals lack.

Small-cap companies derive 77% of their revenue from U.S. customers and have drastically lower reliance on global sales. This domestic focus insulates them from tariff disputes and supply chain disruptions that can hammer international businesses.

Small- and mid-cap companies generally derive a larger portion of their income from domestic sources, which can provide a considerable edge amid trade conflicts. 

If tariff rhetoric escalates or global supply chains face additional pressure in 2026, small caps are positioned to benefit from their limited international exposure.

The fundamental backdrop for small caps is improving. 

Consensus forecasts point to stronger and accelerating profit growth for smaller companies in 2026. 

BofA data indicates that small-cap revenue growth has historically trended upward during periods of rising corporate spending.

The regulatory environment may also shift in small caps' favor. According to a 2023 National Association of Manufacturers study, regulatory burdens fall hardest on the smallest firms. Policy changes that reduce compliance costs could provide meaningful margin relief.

Professional investors have largely avoided small caps. Multi-cap fund managers are currently 60% underweight the segment—the lowest weight since the Global Financial Crisis. But flows are turning.

Bank of America client data shows investors are finally buying small-cap individual stocks this year, and hedge fund inflows have picked up recently.

Retail investor participation in small caps has surged since 2023, averaging 35% to 40% of volume. When retail investors engage heavily with a segment, momentum can build quickly.

iShares Russell 2000 ETF (IWM)

$IWM holds approximately 1,984 companies with assets over $71.38 billion and charges 0.19% in annual operating expenses. The fund provides diversified exposure across the small-cap universe, with top sector allocations to Financials at 18.2%, followed by Industrials and Information Technology.

In August 2025, the Russell 2000 Index ETF surged 7%, and in September 2025, $IWM closed at an all-time high. The ETF tracks approximately 2,000 small-cap companies with a median market cap under $1 billion.

Avantis US Small Cap Value ETF (AVUV)

For investors concerned about unprofitable companies in the small-cap universe, $AVUV offers a refined alternative. The fund is designed to increase expected returns by investing in U.S. small-cap companies trading at low valuations and with higher profitability ratios.

AVUV incorporates mechanisms such as a profitability screen to filter out undesirable value stocks and delivered 11.1% annualized returns from October 2019 through April 2025. 

This compared favorably to DFA's DFSVX at 10.0%, Vanguard's VBR at 8.3%, and iShares' IJS at 5.3% over the same period.

To identify small capitalization, high profitability, or value companies, portfolio managers may use reported and estimated company financials and seek to underweight or exclude securities expected to have lower returns, such as those with lower levels of profitability.

The case for small caps rests on multiple converging factors: extreme valuation discounts relative to large caps, improving earnings momentum, Federal Reserve rate cuts that directly benefit rate-sensitive balance sheets, domestic revenue exposure that shields against trade disputes, and positioning data showing institutional underweights at multi-year extremes.

Tom Lee, Head of Research at Fundstrat, summarized the opportunity: "The valuation spread between large and small caps is at its widest since 1999. If you believe in a soft landing, you have to own the Russell 2000 here."

No investment comes without risk. Small caps carry higher volatility than large caps, and they're more economically sensitive. But for investors with appropriate time horizons who can tolerate near-term fluctuations, the current setup presents a compelling asymmetry between risk and potential reward.

The market has chased mega-cap growth for years. History suggests these trends eventually revert. 

The question isn't whether small caps will outperform—valuations virtually guarantee it over sufficiently long periods. 

The question is when the rotation begins.