Small-Cap Stocks May Be Ready to Outperform After Five Years of Lagging

Small-cap stocks could beat the S&P 500 in 2026. (ANGELA WEISS / AFP via Getty Images)

Key Points

• Small-cap stocks may outperform the S&P 500 in 2026, after five years of underperformance, driven by potential Federal Reserve rate cuts.
• Analysts project Russell 2000 earnings to grow 35% annually over the next two years, significantly higher than the S&P 500’s 14%.
• The Russell 2000 trades at 23.7 times expected earnings, a 5% premium to the S&P 500, which is considered reasonable compared to historical premiums of 15%.

It may sound crazy, but 2026 could finally be the year small-cap stocks beat the S&P 500. They’re on the verge of a breakout.

For each of the past five years, the S&P 500 has outperformed the small-cap Russell 2000—including this year, assuming the major index maintains its lead through the end of the year.

There are clear reasons why. Large-cap technology stocks have surged as investors crowd into companies leading the artificial-intelligence boom. At the same time, investors have favored higher-quality, more established businesses over smaller, lower-quality ones—a common trend when economic growth slows.

That dynamic could be changing. The iShares Russell 2000 exchange-traded fund has rallied from a late-November pullback, beating the S&P 500 over that stretch. The ETF is now trading around $252, barely edging out its $251 record it reached earlier this month.

Any further gains would put the chart into what technical analysts call a “breakout,” a level that signals stronger buying pressure and growing confidence in the market’s outlook.

“A combination of factors that uniquely favor small cap outperformance” is likely, writes Mike Wilson, Morgan Stanley’s chief U.S. equity strategist.

The first factor in Wilson’s thesis is interest rates. The Federal Reserve is widely expected to cut rates this week. While the Fed may stop short of outlining an aggressive rate-cutting path for 2026, there is still a high probability of additional cuts next year. The job market is weakening, which could help drive inflation down toward the Fed’s 2% target.

Lower rates would keep mild economic growth coming. That can keep sales and profits growing for the breadth of non-technology companies that aren’t benefiting from AI growth.

That shifts the focus back to profit growth. Rising volumes and mild inflation can lift margins, and Wilson’s data show expectations for higher revenue have recently outpaced plans to raise worker pay—a signal that margins are likely to expand. Historically, that dynamic has led small-cap earnings to outgrow those of the S&P 500.

Analysts now forecast Russell 2000 earnings to grow 35% annually over the next two years, according to FactSet, versus 14% for the S&P 500.

The Russell 2000 is also less exposed to a potential AI bubble. Trillions of dollars in S&P 500 market value hinge on continued data-center investment from companies such as Microsoft , Meta Platforms , Amazon.com , Alphabet , and Oracle. The Russell 2000 contains far fewer companies tied to that risk, allowing earnings growth to continue even if large-cap tech stumbles.

Valuations, meanwhile, remain reasonable. The Russell trades at 23.7 times expected earnings for the next 12 months, just over a 5% premium to the S&P 500. In prior periods when markets expected rate cuts and sustained growth, that premium has hit about 15%.

The takeaway: small-cap multiples are unlikely to drop if the macro picture unfolds as Wall Street expects. Pair stable valuations with faster earnings growth, and small-caps could finally punch above their weight.

Don’t be afraid to buy some.