The Great Rotation Has Begun: Small-Cap Stocks Post Best Start to a Year in Over a Decade

The first trading day of 2026 delivered a message that stock pickers have been waiting years to hear: the dominance of mega-cap technology stocks may finally be cracking. While the Magnificent Seven retreated, small-cap stocks surged, with the Russell 2000 posting its strongest start to a year in over a decade and outperforming the Nasdaq by nearly 600 basis points over the past month.

The rotation, if it holds, would represent a fundamental shift in market leadership—and potentially the beginning of what JPMorgan calls "the best stockpicking era we have seen in our lifetime."

What's Driving the Rotation

Several forces are converging to lift small-cap stocks while weighing on the mega-caps that dominated 2023 and 2024:

Fed Rate Cuts Taking Hold: The Federal Reserve's 175 basis points of rate cuts since September 2024 are beginning to flow through to the real economy. Small-cap companies, which tend to carry more floating-rate debt and rely more heavily on bank financing, benefit disproportionately from lower rates.

Valuation Reset: After years of underperformance, small caps are cheap. The Russell 2000 trades at approximately 16 times forward earnings—only slightly above its long-term average and dramatically below large-cap valuations. Relative to the S&P 500, small caps are trading at a forward P/E ratio of just 0.72, well below the historical norm of 0.99.

Earnings Acceleration: Analysts expect S&P SmallCap 600 earnings to rise 19% in 2026, significantly outpacing the 13% growth forecast for the S&P 500. This earnings convergence could drive a valuation rerating.

"We are at the gates of the best stockpicking era we have seen in our lifetime. The rotation out of the concentrated mega-caps and into the broader market is just beginning."

— Eduardo Lecubarri, JPMorgan global head of small- and mid-cap equity strategy

The January Effect: Potent This Year

Market watchers are noting that conditions are unusually favorable for the "January Effect"—the historical tendency for small-cap stocks to outperform in the first weeks of the year. After a 2025 that saw extensive tax-loss harvesting in underperforming small caps, many investors are now redeploying capital into names that were oversold for tax reasons rather than fundamental ones.

This rebalancing effect is amplified by institutional flows. The iShares Russell 2000 ETF (IWM) pulled in approximately $3 billion in late December, suggesting that institutional investors are positioning for small-cap outperformance ahead of year-end.

The Historical Case for Small Caps

Over very long time periods, small-cap stocks have outperformed large caps. The size premium—excess returns earned by investing in smaller companies—is one of the most documented phenomena in financial economics. But that premium has been notably absent in recent years, as mega-cap tech captured an outsized share of returns.

History suggests these periods don't last forever. The concentration of returns in a handful of names eventually reverses, and broader market participation follows. Investors who position early for these rotations can capture significant outperformance.

Bank of America's Bullish Call

Bank of America strategist Jill Carey Hall recently declared a bullish stance on the Russell 2000, arguing that small caps will "outperform mid and large caps" in 2026 as economic conditions and market flows turn in their favor.

Her reasoning centers on several factors:

• Economic Momentum: Small caps are more levered to domestic economic growth. If the U.S. economy continues expanding, small companies benefit disproportionately.
• M&A Activity: Lower rates and improving confidence are driving increased merger and acquisition activity. Small caps are the typical targets, and buyout premiums flow to existing shareholders.
• Quality Improving: The Russell 2000 has been reconstituted to reduce exposure to chronically unprofitable companies, improving the index's overall quality profile.

The Risks: Why Bears Remain Cautious

Not everyone is convinced the rotation will persist. Skeptics point to several concerns:

The Refinancing Wall: Approximately 40% of Russell 2000 companies remain unprofitable. Many carry debt that was issued during the low-rate era of 2020-2021 and must be refinanced at higher rates. Even with Fed cuts, current rates are substantially higher than pandemic-era levels.

Economic Uncertainty: Small caps are more vulnerable to economic slowdowns. If tariff concerns materialize or consumer spending weakens, smaller companies with less financial cushion could suffer disproportionately.

AI Concentration: The artificial intelligence theme continues driving enormous capital flows into the companies building AI infrastructure. This dynamic has persisted longer than many expected and could continue.

How to Position

For investors considering a small-cap allocation, several approaches warrant consideration:

Broad Index Exposure: The simplest approach is buying a broad Russell 2000 index fund or ETF. This provides diversified exposure to the asset class without requiring individual stock selection.

Quality Screens: Given the risks associated with unprofitable companies in the index, many advisors suggest applying quality screens—focusing on small caps with positive earnings, reasonable debt levels, and proven business models.

Value Tilt: Small-cap value stocks have historically outperformed small-cap growth over long periods. Value-oriented small-cap funds may offer better risk-adjusted returns than growth-focused alternatives.

The Bottom Line

The first days of 2026 suggest a meaningful shift in market dynamics. Whether this proves to be the start of a sustained rotation or simply a short-term adjustment remains to be seen. But for investors who've watched mega-cap tech dominate for years, the early signals offer something that's been in short supply: hope that market breadth will finally expand.

After three years of narrow leadership, the broadening of the rally to include smaller companies would be a healthy development for markets. It would validate the economic recovery, reward patient investors who maintained diversified portfolios, and potentially signal that the best stockpicking environment in years is at hand.