As of January 6, 2026, the iShares Russell 2000 ETF (IWM) has surged an impressive 6.2%, marking one of the strongest seasonal openings in recent history. The first trading week of 2026 has delivered a powerful resurgence of the "January Effect," with small-cap stocks staging a massive rally that has outpaced their mega-cap counterparts.

The Perfect Storm for Small Caps

This early-year momentum is being driven by what analysts are calling a "perfect storm" of catalysts: a pivot in Federal Reserve policy, significant geopolitical developments, and a massive valuation gap that has finally become too large for institutional investors to ignore.

While the broader S&P 500 and Nasdaq Composite have remained relatively flat due to elevated valuations in big tech, the "Great Rotation" into undervalued domestic companies is now in full swing.

The Valuation Gap: Too Big to Ignore

Entering 2026, U.S. small caps were trading at a nearly 26% discount to large caps—a level near historic lows. This valuation gap, combined with projected 35% earnings growth for Russell 2000 companies over the next two years, has made the sector an irresistible target for fresh capital.

For context, consider the divergence: while the Magnificent Seven tech stocks trade at forward price-to-earnings ratios often exceeding 30x, many small-cap industrials and financials can be found at single-digit multiples with comparable or superior growth prospects.

2025 Set the Stage

The setup for this rotation was built throughout 2025. For the full year, the Russell Microcap gained 23.0%, the Russell 2000 rose 12.8%, while the Russell 1000 advanced 17.4% and the Russell Top 50 increased 19.9%.

The Federal Reserve's easing cycle, which began in September 2025 with three consecutive 25-basis-point cuts to end the year at a range of 3.50%–3.75%, has been particularly beneficial for small caps. These companies typically carry more floating-rate debt than their larger counterparts, meaning lower rates directly improve their bottom lines.

Wall Street Is Paying Attention

Strategists from firms including Bank of America, JPMorgan Chase, BTIG, and Polar Capital see the recent small-cap leadership extending into 2026. Their bullish case hinges on continued rate cuts, economic growth, and diversification out of what they view as frothy megacaps.

"The valuation gap between small and large caps is at levels we've rarely seen," noted one strategist. "Combined with accelerating earnings growth in the Russell 2000, the risk-reward favors small caps for patient investors."

Sector Leaders in the Rally

Within the small-cap universe, certain sectors are leading the charge:

  • Regional Banks: Benefiting from a steepening yield curve and expectations of M&A activity
  • Industrials: Riding the reshoring wave and infrastructure spending
  • Energy Services: Capitalizing on domestic production growth
  • Healthcare: Particularly biotechs with near-term catalysts

The Cautionary Voice

Not everyone is fully on board. JPMorgan analysts have cautioned that the Russell 2000 may face limited upside in the first half of 2026, citing potential interest rate pressures and historical trading patterns as factors that could constrain gains.

Additionally, small caps are inherently more volatile and economically sensitive. Should the U.S. economy slow more than expected, these companies could face disproportionate pressure compared to their larger, more diversified peers.

What Investors Should Consider

For investors considering a small-cap allocation, several factors merit attention:

  • Quality matters: Not all small caps are created equal. Focus on companies with strong balance sheets, proven business models, and sustainable competitive advantages.
  • Diversification is key: Given the inherent volatility of the asset class, broad-based ETFs like IWM or active managers with strong track records may be preferable to concentrated bets.
  • Time horizon: The valuation gap may take time to close. Investors should be prepared for periods of underperformance along the way.

The Great Rotation appears to be underway, but as with any market shift, patience and discipline will separate the winners from the crowd.