For years, investors watched helplessly as mega-cap technology stocks dominated returns while small-cap companies languished. That story is finally changing. The Russell 2000 index has surged to record highs above 2,500, outpacing the S&P 500 by its widest margin in over a decade.

Market watchers are calling it "The Great Rotation"—a fundamental shift away from the overextended valuations of trillion-dollar tech giants toward the domestically-focused, cyclically-sensitive companies that form the backbone of the American economy.

By the Numbers

The Russell 2000 has climbed approximately 12.1% in 2025, a solid performance that accelerated dramatically in the year's second half. From July through December, small-cap futures rose 16%, compared to just 11% for the S&P 500.

The index touched an all-time closing high of 2,590.61 in mid-December before consolidating around the 2,500 level. This represents a marked improvement from years of relative underperformance against the large-cap benchmark.

What's Driving the Small-Cap Surge

Federal Reserve Rate Cuts

Small-cap companies, which typically carry more floating-rate debt than their larger counterparts, have been disproportionately burdened by high interest rates. The Fed's three rate cuts in 2025—bringing the federal funds rate down to 3.50-3.75%—lifted this weight from small-cap balance sheets.

"The crushing weight of high borrowing costs—which disproportionately affected smaller firms—has finally lifted."

— Franklin Templeton Research

The One Big Beautiful Bill Act

The fiscal transformation that began in July 2025 with the passage of the One Big Beautiful Bill Act (OBBBA) provided substantial tailwinds for small businesses. This $4.5 trillion legislative package introduced permanent 100% bonus depreciation for capital investments and raised the Section 179 expensing limit to $2.5 million.

These provisions disproportionately benefit smaller, capital-intensive businesses that can now immediately expense equipment purchases rather than depreciating them over years.

Earnings Growth Acceleration

Perhaps the most compelling case for small caps lies in their earnings outlook. Consensus estimates for Russell 2000 earnings per share growth in 2025 reached 44%, dwarfing the slowing growth rates of tech-heavy indices.

Looking ahead, FactSet projects small caps growing profits by approximately 22% in 2026, compared to just 15% for large caps. This earnings growth differential is attracting institutional capital that had long overlooked the asset class.

Valuation Gap Narrows

For much of the past decade, small caps traded at historically low valuations relative to large caps. This gap is finally narrowing as investors recognize the fundamental improvement in small-cap earnings quality.

The Russell 2000 trades at approximately 18 times forward earnings, compared to over 22 times for the S&P 500. This discount, while narrower than a year ago, still offers value-oriented investors an attractive entry point.

Sector Leadership

Within the small-cap universe, certain sectors have led the charge:

  • Financials: Regional banks have benefited from rising net interest margins as the yield curve normalized.
  • Industrials: Manufacturing companies tied to infrastructure spending and reshoring trends have outperformed.
  • Healthcare: Biotech firms, particularly those with near-term catalysts, have attracted speculative capital.
  • Energy: Small-cap energy producers have capitalized on elevated oil prices and disciplined capital allocation.

The Domestic Advantage

Unlike multinational corporations in the S&P 500, Russell 2000 companies derive the vast majority of their revenues from the United States. This domestic focus provides insulation from currency volatility, geopolitical tensions, and the dollar's weakness.

In a year when tariff uncertainty roiled global trade, small caps' home-field advantage proved valuable.

Risks to Monitor

The small-cap rally is not without risks:

  • Economic sensitivity: Small caps tend to underperform during recessions. Any deterioration in economic conditions could reverse the rotation.
  • Liquidity concerns: Small-cap stocks are inherently less liquid than large caps, which can amplify volatility during market stress.
  • Quality dispersion: The Russell 2000 contains a wide range of quality levels, including many unprofitable companies. Stock selection matters more in small caps than in large-cap indices.

What This Means for 2026

The combination of lower interest rates, fiscal stimulus, superior earnings growth, and attractive valuations creates a favorable backdrop for small caps heading into 2026.

For investors who have underweighted small caps during the AI-driven mega-cap mania, The Great Rotation presents an opportunity to rebalance portfolios toward a more diversified market exposure.

Whether this represents the beginning of a sustained small-cap cycle or a temporary rotation remains to be seen. But after years of large-cap dominance, the Russell 2000's breakout to record highs suggests the market's leadership may be broadening at last.