The Great Rotation: Russell 2000 Posts Best January Start in a Decade as Small Caps Crush Large Caps

For years, investors who bet on small cap stocks watched enviously as mega-cap technology companies dominated market returns. That dynamic is now reversing dramatically. The Russell 2000 Index has surged 5.8% since the start of 2026—its strongest January performance in over a decade—as a powerful rotation reshapes the investment landscape.

The Rotation Takes Hold

Through mid-January, the Russell 2000 has gained 5.8% while the S&P 500 has advanced just 1.2%. The small cap index has now outperformed the large cap benchmark for 11 consecutive trading sessions—a streak that market technicians say represents a meaningful shift in market leadership rather than a temporary blip.

The rotation reflects a confluence of factors that have simultaneously boosted small caps while weighing on the mega-cap technology companies that dominated returns in 2024 and 2025. Lower interest rates, attractive valuations, and renewed optimism about domestic economic growth have all contributed to small caps' resurgence.

"This isn't just a trade—it's a potential regime change. The valuation gap between small and large caps had reached a 25-year extreme by the end of 2025. That kind of dislocation rarely persists, and we're now seeing it correct."

— Market strategist analysis

Valuations: A Coiled Spring

By late 2025, the valuation gap between small and large caps had reached extraordinary proportions. The Russell 2000 traded at a forward price-to-earnings ratio of roughly 18x, while the S&P 500 hovered near 26x. For value-conscious investors, small caps represented a "coiled spring" ready to unwind.

As of early January 2026, the Russell 2000 still trades at just 18.11x earnings—a meaningful discount to historical averages and substantially below large cap valuations. This discount has attracted flows from institutional investors seeking more attractive risk-reward profiles.

Valuation Comparison:

• Russell 2000 P/E: 18.1x
• S&P 500 P/E: 22.3x
• Discount: 19%
• Historical Average Discount: 5-10%

Rate Cuts Benefit Smaller Companies Disproportionately

The Federal Reserve's decision to cut rates 75 basis points in late 2025, bringing the federal funds rate to a 3.50%-3.75% range, has provided crucial support for small cap stocks. Smaller companies typically carry higher levels of floating-rate debt and rely more heavily on external financing—meaning they benefit disproportionately when borrowing costs decline.

With the Fed expected to continue easing this year, albeit gradually, the interest rate tailwind for small caps appears likely to persist. Lower rates not only reduce debt servicing costs but also support the merger and acquisition activity that small cap investors often count on for returns.

Domestic Focus Provides Insulation

Unlike multinational mega-caps with significant overseas exposure, Russell 2000 companies derive the vast majority of their revenue from domestic sources. This U.S.-centric orientation provides a degree of insulation from trade tensions and tariff concerns that have weighed on companies with substantial international operations.

With the Trump administration maintaining an aggressive stance on trade policy, companies with primarily domestic revenue bases face less uncertainty about supply chains, tariffs, and foreign exchange fluctuations. This relative predictability has attracted investors seeking shelter from geopolitical turbulence.

Small Cap Value Leading the Charge

Within the small cap universe, value stocks have shown particular strength. The Vanguard Small-Cap Value ETF (VBR) has seen record inflows in recent weeks as investors seek the double tailwind of small cap outperformance and value factor exposure.

Many small cap value stocks trade at steep discounts to intrinsic value, reflecting years of underperformance and institutional neglect. As these stocks re-rate higher, early investors stand to benefit from both earnings growth and multiple expansion.

Earnings Growth Expected to Accelerate

Consensus forecasts project 5-7% earnings growth for Russell 2000 companies in the first quarter of 2026—a meaningful acceleration from recent quarters. If these estimates prove accurate, sustained profit improvement could justify further multiple expansion and continued outperformance.

The earnings trajectory for small caps has historically been more volatile than for large caps, but current estimates suggest a favorable setup. With revenue growth inflecting higher and cost pressures easing, profit margins for many smaller companies appear poised to expand.

What Could Derail the Rally

Small cap investors should remain alert to potential headwinds. A recession—while not most economists' base case—would disproportionately impact smaller, more cyclically sensitive companies. Similarly, a sharp reversal in interest rate expectations could remove a key pillar of support for the trade.

Additionally, while valuations are attractive in aggregate, dispersion within the Russell 2000 remains wide. Active selection will likely prove important, as not all small caps are positioned to benefit equally from current conditions.

How to Position

For investors looking to capitalize on the small cap rotation, several approaches merit consideration:

• Broad Exposure: Low-cost index funds tracking the Russell 2000 provide diversified exposure to the asset class.
• Value Tilt: Small cap value funds offer potential for additional outperformance if value factors continue to work.
• Quality Screen: Focusing on small caps with strong balance sheets and consistent profitability can help manage volatility.
• Sector Selection: Financials, industrials, and energy have shown particular strength within the small cap space.

The great rotation may have further to run. With valuations still attractive, interest rates declining, and domestic economic growth resilient, small cap stocks appear well-positioned for continued outperformance—though prudent diversification remains essential.