“It’s a world of laughter
And a world of tears
It’s a world of hopes
And a world of fears
There’s so much that we share
That it’s time we’re aware
It’s a small world after all”
(From “It’s a Small World” by the Sherman Brothers, 1964, written at the request of Walt Disney as the theme song for a Disneyland ride of the same name)
By Scott Welch, CIMA®, CEPA®, Chief Investment Officer & Partner
Reviewed by Carter Mecham, CMA®, IACCP®
A Summary of the Recent Small Cap Rall
For most of the past ten years in the US, large cap stocks have dominated over small cap stocks, driven in no small part by the runaway bull market in the mega-cap tech stocks since roughly 2023.
Source: Ycharts, 10-year data through May 6, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
If we go back thirty years, however, we see a much tighter dispersion of performance and, in fact, an outperformance by the S&P 500 equal-weighted index, which gives every stock in the index an equal weighting versus the more traditional market-cap weighted index (which skews heavily toward the largest stocks in the index).
Source: Ycharts, 10-year data through May 6, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
But perhaps of more immediate relevance to many investors is the sudden “asset class rotation” that began in November of 2025, when small caps suddenly overtook large caps in the US and have been outperforming ever since (though the strong large cap rally of the past several weeks has closed the gap with the equal-weighted index).
Source: Ycharts, 6-month data through May 6, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
We see similar results if we look at non-US markets. Going back 25 years, Developed International (EAFE) small caps have dominated large caps.
Source: Ycharts, data from January 2, 2001 through May 6, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
Again, perhaps more relevant to most investors, after underperforming for much of the past 10 years, this outperformance returned over the past 12 months.
Source: Ycharts, 12-month data through May 6, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
The Emerging Markets (EM) show a more varied performance comparison – EM small caps have outperformed over the past five years (first chart) but underperformed over the past year (second chart).
Source: Ycharts, 5-year data through May 6, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
Source: Ycharts, 12-month data through May 6, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
What is Causing the Current Outperformance of Small Caps — and Can it Continue?
The first thing to note is that small caps outperformed large caps in roughly 50% of the past 45 calendar years (23 times between 1980 and 2025), and over that period generated an average annual spread premium of 1.5% (skewed heavily by a 47% positive spread in 2001 following the dot.com bust).
Annual return spread = Russell 2000 total return − S&P 500 total return. 2026 bar is YTD through April 30, 2026 (Russell 2000 +12.7% vs S&P 500 +5.1% as of May 1). Pre-1984 approximated using Ibbotson small-cap index. Sources: FactSet, Trade That Swing, RBC Wealth Management. You cannot invest in an index, and past performance is no guarantee of future results.
The second thing to note is that, when small cap stocks begin to outperform, that trend tends to last for multiple years.
Source: Bloomberg. Northern Trust Global Asset Allocation Quantitative Research. Data from January 1, 1930–December 31, 2024. Light green indicates those periods when small cap stocks have outperformed. Dark green indicates those periods when large cap stocks have outperformed. Note: 10-year return spread is calculated as rolling 10-year annualized total return spread between Russell 2000 and Russell 1000 Indices. Prior to 1979, return data is based off S&P 500 Index and US Small Caps (bottom decile) total return time series downloaded from New York University. You cannot invest in an index, and past performance is no guarantee of future results.
A final note on historical performance is that, on a cumulative basis, small caps consistently outperformed large caps from 2000 until the end of 2020.
Since that time, however – driven by the mega-cap tech stocks – small cap stocks have given up all of that cumulative outperformance, and more.
Sources: Slickcharts.com, statmuse.com, New York University, and MacroTrends, data from 2000 – 2024. You cannot invest in an index, and past performance is no guarantee of future results.
So, the question is whether or not the recent small cap rally can continue. To start this discussion, we need to make a distinction between a continuation of the small cap rally and a continuation of small caps outperforming large caps.
For reasons summarized below, we believe the answer to the first question is yes, but the answer to the second question might be “maybe not”.
The current market environment is being driven by technology and AI-related stocks, and it is quite possible that a momentum- and sentiment-driven rally in the semiconductor and mega-cap tech stocks – which have been on an absolute tear the past 3-4 weeks – may pull large caps ahead over the next several months.
Take a look at the comparative performance of the semiconductor industry (as proxied by the Philadelphia Semiconductor Sector index, or “SOX”) over the past twelve months.
Source: Ycharts, 12-month data through May 7, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
Another way of illustrating the strength of the semiconductor industry is to examine the performance of the South Korean stock market index, the “KOSPI”, which is dominated by Samsung (a global producer of semiconductors) and SK Hynix (a global memory chip producer).
ETFs listed are for illustration purposes only and do not represent investment advice. You cannot invest in an index, and past performance is no guarantee of future results.
Finally, though the market is clearly beginning to separate perceived winners from losers in the AI race, the meg-cap tech stocks have enjoyed a solid rally overall over the past month.
Source: Ycharts, 1-month data through May 7, 2026. The stocks listed are for illustration purposes only and do not represent investment advice. Past performance is no guarantee of future results.
But none of this would be a reason to ignore small caps.
Earnings
While the earnings expectations across all capitalization levels in the US are expected to grow strongly over the course of 2026, current expectations are for small cap earnings to outpace large cap earnings on a percentage basis.
Source: Ycharts, through April 30, 2026. These are estimates and subject to change as additional data come in. You cannot invest in an index, and past performance is no guarantee of future results.
Source: Siblis Research, Zacks, Lipper, and FactSet. Estimates are for 2026 earnings growth for the S&P 500 and the Russell 2000 indices. These are estimates and subject to change as additional data come in. You cannot invest in an index, and past performance is no guarantee of future results.
Valuations
While most global valuations are elevated vs. historical levels, US large cap stocks in particular (skewed by the mega-cap tech stocks) are significantly more expensive than small- and mid-cap stocks.
Source: Yardeni Research, as of May 7, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
As mentioned, though, the valuation of the overall S&P 500 index is heavily skewed by the mega-cap tech stocks.
Source: Yardeni Research, as of May 5, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
Source: Yardeni Research, as of May 5, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
In terms of trading discounts, small cap stocks are trading at the lowest relative valuation to large caps in more than twenty years.
Source: WisdomTree, data through April 30, 2026. You cannot invest in an index, and past performance is no guarantee of future results.
It is important to note that valuations in and by themselves are not a “trading signal”, as momentum and investor sentiment can drive market trends far longer than market fundamentals might suggest.
What these charts do, suggest, however, is there may be potential relative value in small cap stocks versus large caps as we move through the next market cycle.
Economic and Market Regime
Which bring us to our final area of analysis – where are we in the current economic and market cycle and when have small cap stocks historically performed best during those cycles?
We begin with a reminder of the four general “quadrants” or the economic cycle, based on whether the economy and inflation are rising or falling.
For illustration purposes only.
This is not a static scenario – the economy is constantly “cycling” through each of these quadrants.
Source: MSN.com. For illustration purposes only.
So, where might we be right now, and how does that impact the outlook for small cap stocks?
This, of course, is a matter of interpretation and different people may have different opinions. But we suggest we might be in an environment characterized by a slowly rising or peaking economy – historically a positive environment for small caps.
Source: MRB Partners. For illustration purposes only and does not represent investment advice.
Likewise with inflation – small cap stocks historically performed best in markets characterized by stable to moderate inflation, which is a reasonable approximation of where we currently sit. Note, however, that performance tends to fall off if inflation climbs too high.
Source: Russell, the Federal Reserve, Bureau of Labor Statistics. For illustration purposes only and does not represent investment advice.
Historical small cap performance can, therefore, be summarized as follows:
For illustration purposes only and does not represent investment advice. Past performance is no guarantee of future results.
Finally, how do small cap stocks perform in different interest rate environments?
Historically, because of their heavier dependence on floating rate debt, small cap stocks tend to perform better in falling rate environments, but this is mitigated to some degree if rates are rising because the economy is expanding and/or the overall market is rallying (both of which seem to be currently in place).
Source: BNP Paribas Asset Management, January 2025. For illustration purposes and does not represent investment advice. Past performance is no guarantee of future results.
Source: Citi Private Bank, “Why small can be beautiful in the stock markets,” February 2025. For illustration purposes and does not represent investment advice. Past performance is no guarantee of future results.
Summary & Interpretation
Trying to predict future market performance is somewhat of a fool’s game. We believe the best you can do is analyze the information you have and try to make informed decisions.
Based on the historical performance of small cap stocks under different economic and market regimes, we believe they have a good chance of continuing the strong performance we’ve enjoyed over the past twelve months.
As long as the market remains infatuated with AI, we suspect that large cap stocks will soon (once again) overtake market leadership in performance.
But we believe the argument is strong for maintaining an appropriate allocation to smaller cap stocks (e.g., equal-weighted S&P 500, S&P 400, and S&P 600).
We believe the Fed is in a “holding pattern” with respect to rates. We see no particular catalyst for a rate cut, but neither do we see one for a rate hike, either, unless inflation continues to rise.
With respect to small cap stocks, we seem to be in a bit of a “sweet spot” with respect to the economy, inflation, and interest rates.
As philosophical believers in global diversification, we maintain our conviction that small cap stocks (both US and non-US) deserve allocation within a diversified portfolio.
As always, we welcome your questions and feedback.