Small-Caps, Diversification, and the Broadening Market Rally
For the financial media and the broad investor community, the overwhelming focus over the past year has been on mega-cap technology stocks. But that has meant overlooking a more interesting story, in my view—the strong performance of small-cap stocks.
With little fanfare, the Russell 2000 index of small-cap stocks has outperformed the S&P 500 index in the second quarter and over the past year, by a fairly significant margin in both periods. For a segment of the market that spent several years lagging large-cap stocks, this marks a meaningful shift.
There are a few reasons for the recent strength, in my view. The first is valuation. As small-caps entered 2026 following a stretch of underperformance versus large-caps, the asset class was trading at a meaningful discount. As seen in the relative valuation chart below, the Russell 2000 trades at its cheapest level relative to the Russell 1000 in 25 years.
Cheap valuations alone are never enough to support a lasting rally, but they can create a more attractive starting point when fundamentals improve—which they did.
Consensus expectations for Russell 2000 earnings growth have risen to 38% from roughly 23% at the start of the year. Large-caps have also seen nicely positive revisions to earnings estimates, but not by a factor of nearly two. As such, not only did small-caps get cheaper relative to large-caps, they also saw more dramatic improvement in profit expectations. That’s a formula for outperformance.
The third driver behind strong small-cap performance is the broadening of the artificial intelligence investment cycle. AI is often discussed as a mega-cap technology story, but the buildout of data centers, computing infrastructure, power systems, industrial equipment, and semiconductor supply chains reaches well beyond the largest companies. Smaller suppliers have also benefited, with AI infrastructure stocks contributing roughly 40% of the Russell 2000’s year-to-date return through mid-2026.
Investors may be wondering if this means that small-caps may be the next asset class with a ‘concentration problem,’ i.e., a handful of stocks driving overall index returns. That’s on our radar, too, but we also know that small-cap indexes contain a wide range of companies—profitable businesses with strong balance sheets, earlier-stage firms still scaling, niche industrial suppliers, regional banks, healthcare and biotech companies, technology hardware firms, and many others. Selection is key.
The more important point here, however, is remembering the role small-caps can play in a portfolio over time. Large-cap stocks may provide exposure to global market leaders, strong balance sheets, and dominant franchises. Small-caps can add exposure to earlier-stage growth, domestic economic momentum, innovation, acquisition targets, and companies with more room to expand from a smaller base. For growth-oriented equity investors, that can be a valuable asset.
Bottom Line for Investors
Small-cap performance may be sending a constructive signal to the broader equity landscape, suggesting that the market rally may be broadening. When more areas of the market begin participating, it can point to improving confidence in the broader economy and a more balanced set of opportunities. That’s a good thing, in my view.
After several years of large-cap dominance, stronger small-cap performance suggests investors are finding opportunity in a wider range of companies, sectors, and earnings drivers. That does not eliminate the risks tied to rates, credit conditions, or earnings volatility, but it does make the rally look less dependent on a narrow group of mega-cap leaders and more reflective of improving confidence across the broader equity market.
Disclosure
Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.
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