“The waiting is the hardest part
Every day get one more yard
You take it on faith, you take it to the heart
Yeah, the waiting is the hardest part.”
(From “The Waiting” by Tom Petty & the Heartbreakers, 1981)
By Scott Welch, CIMA®, CEPA®, Chief Investment Officer & Partner
Reviewed by Carter Mecham, CMA®, IACCP®
As long-term strategic investors, we believe in the academic and empirical support for allocating to small cap stocks. Until recently, historical performance indicates that there is validity to the notion of a “size premium.” It doesn’t always outperform, of course, but when it has it (a) has outperformed by a lot, and (b) it tends to outperform for extended periods of time.
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.
What you see from this chart, however, is that small cap stocks have significantly underperformed for more than ten years. We can visualize this more dramatically if we compare the cumulative performances of the S&P 500, S&P 600, and S&P Equal-Weighted indexes over the past twenty years. The results may surprise some of you.
Source: Ycharts, 20-year data through September 15, 2025. You cannot invest in an index and past performance is no guarantee of future results.
We suspect few investors would have known or guessed that the S&P Equal-Weighted index has been the best long-term performer (though it does support the notion that a “size premium” does exist).
Market Forces
If we drill down to a shorter time period and focus just on the cap-weighted large cap and small cap indexes, we see that the majority of the outperformance by large caps has occurred in the past two years – corresponding to the explosive AI-fueled returns in the mega-cap tech stocks over that same period.
Source: Ycharts, 5-year data through September 15, 2025. You cannot invest in an index and past performance is no guarantee of future results.
In addition to the AI phenomenon, we believe there may be a second reason small cap stocks have underperformed over most of the past ten years: the growth in private equity.
It simply is a fact that there are far fewer publicly traded companies than there used to be.
Source: Forbes, February 3, 2025. The tally of publicly traded companies in the U.S. fell from about 8,090 in 1997 to just 3,952 by the end of 2024. Chart Created and Owned by Capital Investment Advisors Using Bloomberg Terminal Software.
At the same time, the number of privately held or PE-sponsored companies has correspondingly increased.
Source: PitchBook | LCD, World Federation of Exchanges database, iCapital Alternatives Decoded, with data based on availability Jul. 31, 2025. Note: Data as of December 2024 for PE-backed and as of December 2023 for publicly listed. Data is subject to change based on potential updates to source(s) database. U.S. PE-backed companies are all privately held companies with private equity backing. We exclude VC-backed companies. For illustration purposes only. Past performance is no guarantee of future results.
The reasons for this shift from public to private are myriad, including the ever-increasing regulatory, reporting, and governance burdens placed on public companies. The requirement for quarterly earnings reporting may also discourage some companies from going public because their business model requires a longer strategic time horizon versus “beating their numbers” every quarter. [Note: The Trump Administration has floated the idea of eliminating quarterly reporting requirements for publicly traded companies. We believe this is a good idea conceptually but, of course, the devil is in the details and there is no guarantee any proposed legislation would pass.]
The effect on small cap stocks is hard to quantify, but a reasonable argument can be made that the small cap companies that historically drove performance (a) are currently private and don’t want to go public, (b) are staying private longer (partially due to a somewhat dormant IPO market over the past several years), or (c) were publicly traded but then were purchased and taken private by PE firms, which are awash with “dry powder” to invest due to heavy investor inflows over the past several years.
Source: Pitchbook, data as of September 30, 2024.
Economic Forces
In addition to market forces (some of which may be difficult to quantify), there are economic forces as well that may be contributing to recent small cap underperformance.
First, let’s note that roughly 30% of the companies that make up the Russell 2000 small cap index report negative earnings (that number is under 15% for the higher quality S&P 600 small cap index). If you want an illustration of a “junk rally,” look no further.
Source: Ycharts, 12-month data through September 12, 2025. You cannot invest in an index and past performance is no guarantee of future results.
The point is that, as a generalized asset class, small cap stocks have weaker balance sheets, earnings, and cash flows and are more sensitive than their large cap brethren to both the economic and interest rate environments. Specifically, they tend to use a much higher percentage of floating rate debt to fund their businesses and so are particularly sensitive to changes in short-term interest rates.
Source: Ycharts, 20-year data through September 12, 2025. The shaded grey bars represent recessions. You cannot invest in an index and past performance is no guarantee of future results.
Source: Bloomberg, BNP Paribas Asset Management. Data as of January 13, 2025. You cannot invest in an index and past performance is no guarantee of future results.
To summarize, the current multi-year underperformance of small cap stocks can be attributed to:
- The unprecedented rally in mega-cap tech stocks
- A relatively benign economic environment, which tends to favor large cap stocks
- A rising interest rate environment over the past 12-15 months (that will change soon, at least at the short end)
- The reduction of publicly traded small cap stocks, the trend toward remaining private for longer, and/or public companies transitioning from public to private, and
- The accompanying explosion in the growth of private equity
So, Where Do We Go from Here?
Is the recent underperformance of small cap stocks here to stay? Is the current market regime finally an actual example of “this time it’s different”? Is the size premium dead?
Perhaps, but we think it more likely that, to paraphrase Mark Twain, “The rumor of the demise of small cap stocks has been greatly exaggerated.”
Let’s take a look as to why that may be true.
First, let’s simply look at comparative market performances over the past three months. This is far too short a time period to suggest a trend, but it does represent a distinct change from performances over the past several years.
Source: Ycharts, 3-month data through September 12, 2025. You cannot invest in an index and past performance is no guarantee of future results.
As we write this, the Fed just cut rates by 25-bps in its September FOMC meeting, and the market is forecasting 2-3 more cuts before year-end.
Source: The Atlanta Fed “Market Probability Tracker” as of September 15, 2025. These are forecasts and subject to change as additional data come in.
With this in mind, we note that small cap stocks historically have outperformed in falling rate environments (partially due to their heavier dependence on floating rate debt).
Source: Neuberger Berman Research, Fama French Database, and FactSet. Data as of June 30, 2024. For illustration purposes only. You cannot invest in an index and past performance is no guarantee of future results.
Next, we look at relative valuations, and here we see a valuation gap between large and small caps as wide as it has been since the tech boom of the early 2000s (and we know how that ended).
Throughout investment history, this level of valuation dispersion has never lasted, and it won’t this time, either. At some point, either large cap valuations will come down or small cap valuations will rise up. But eventually, they will move in the direction of convergence.
Source Yardeni Research, as of September 12, 2025. You cannot invest in an index and past performance is no guarantee of future results.
Source: WisdomTree, FactSet, data as of July 31 (top) and September 11 (bottom), 2025. You cannot invest in an index and past performance is no guarantee of future results.
Finally, let’s look at earnings growth potential. Many analysts expect small caps to generate a higher level of earnings growth than large caps over the next several years but, even if this is true, it needs to be interpreted correctly.
A higher earnings growth rate for small caps does not suggest higher earnings, only that the gap that has existed between the growth rates for large and small cap stocks – like valuations – will narrow.
Source: Royce Investment Partners “U.S. Small-Cap Market Overview, as of June 30, 2025. These are forecasts and subject to change as additional data come in. You cannot invest in an index and past performance is no guarantee of future results.
Summary and Conclusions
It has been difficult to defend our strategic allocation to US small cap stocks for the past few years, and we understand why.
But we’ve been through enough market cycles to believe that (a) nothing lasts forever, (b) fundamentals eventually always matter, and (c) markets do tend to “mean converge.”
We are not suggesting the current dominance of large cap stocks (specifically the mega-cap tech stocks) cannot or will not continue, at least for a while.
But we do believe that professional investors, at some point, will begin to harvest their gains and reallocate to more reasonably valued companies.
We also believe that the underlying market dynamics and current economic and interest rate environments bode well for the potential of small cap stocks.
As believers in both long-term strategic asset allocation and in building “all-weather” portfolios, we remain comfortable with having our portfolios diversified at both the asset class and risk factor levels.
Even if, as Tom Petty so accurately sang it, “The waiting is the hardest part.”
As always, we welcome your questions and feedback.