After years of playing second fiddle to the megacap technology giants, small-cap stocks are staging a remarkable comeback. The Russell 2000 index surged to new all-time highs this week, delivering one of the strongest January openings in recent memory as investors execute what Wall Street has dubbed the "Great Rotation."

The iShares Russell 2000 ETF (IWM) jumped an impressive 6.2% in the first trading week of 2026, a performance that has caught the attention of institutional investors and retail traders alike. Meanwhile, the S&P 500 and tech-heavy Nasdaq 100 have remained largely flat, weighed down by profit-taking in the Magnificent Seven stocks.

The January Effect in Full Force

The "January Effect"—the historical tendency for small-cap stocks to outperform in the first month of the year—appears to be manifesting with unusual vigor in 2026. Historically, this phenomenon occurs as investors rebalance portfolios after year-end tax-loss selling and seek undervalued opportunities.

But this year's small-cap surge has deeper roots than seasonal patterns alone. The combination of Fed rate cuts, compelling valuations, and what some analysts describe as "AI fatigue" among large-cap technology investors has created a perfect storm for smaller companies.

"We are at the gates of the best stockpicking era we have seen in our lifetime."

— Eduardo Lecubarri, Global Head of Small- and Mid-Cap Equity Strategy, JPMorgan

Why Small Caps Now?

Several catalysts have converged to drive the small-cap rally:

1. The Valuation Gap

Entering 2026, U.S. small-cap stocks were trading at a nearly 26% discount to large caps—a level approaching historic lows. This valuation disparity, combined with improving earnings prospects, has made smaller companies increasingly attractive to value-oriented investors.

2. Fed Rate Cuts

The Federal Reserve's three consecutive rate cuts in late 2025, which brought the federal funds rate down to a range of 3.50%–3.75%, have been a tailwind for small caps. Smaller companies typically carry more floating-rate debt than their larger counterparts, making them particularly sensitive to interest rate changes.

Lower borrowing costs directly improve profitability for these companies, and the prospect of additional cuts in 2026—Treasury Secretary Bessent is publicly pushing for more—adds to the bullish case.

3. Earnings Inflection Point

On the fundamental side, small-cap earnings growth for 2026 is projected to hit an inflection point. Consensus estimates forecast a 17% to 22% increase in earnings, significantly outpacing the 14% growth expected for the S&P 500. This earnings differential is drawing institutional capital into the space.

4. Market Breadth Improvement

Technical indicators support the rally's sustainability. On the day the Russell 2000 hit its record high, over 60% of stocks in the index finished in positive territory—the highest level of market participation seen in three years. This broad-based advance suggests the rally has substance rather than being driven by a handful of names.

The 'Great Rotation' Takes Hold

For months, Wall Street strategists have predicted a rotation from the market's largest companies into smaller, more economically sensitive stocks. That rotation appears to be materializing.

Apple shares have fallen for seven consecutive sessions as investors book profits. Nvidia, the AI darling that powered much of 2025's market gains, dropped more than 2% on Thursday as what some analysts call "AI fatigue" set in. Oracle also pulled back nearly 2%.

The money flowing out of mega-cap tech has to go somewhere, and increasingly, it's finding a home in small caps. The trade reflects a belief that the easy gains from AI enthusiasm have been captured, while the broader economy—and the smaller companies tied to it—may be poised for stronger performance.

Wall Street's Bullish Outlook

Major investment banks are jumping on the small-cap bandwagon:

  • Jefferies has set a year-end 2026 target of 2,825 for the Russell 2000, suggesting another 14% upside from current levels
  • JPMorgan recommends being overweight small- and mid-cap stocks versus larger names in developed markets
  • Goldman Sachs sees small caps benefiting from the continued normalization of monetary policy

Eduardo Lecubarri of JPMorgan has been particularly emphatic, declaring that he's "convinced" 2026 is the year to favor smaller companies. His thesis rests on the combination of attractive valuations, improving fundamentals, and a more supportive interest rate environment.

Risks to Consider

Despite the bullish momentum, investors should be aware of potential headwinds:

The 2026 Refinancing Wall

Many small-cap companies face significant debt maturities in 2026. While interest rates have come down, they remain well above the near-zero levels of the pandemic era. Companies will need to demonstrate they can manage their debt loads while still investing in growth.

Economic Sensitivity

Small caps are more exposed to the domestic economy than their larger, more globally diversified counterparts. If economic growth disappoints—particularly if the labor market weakens faster than expected—small caps could underperform.

Limited Upside in First Half?

Some analysts, including JPMorgan's own strategists, have cautioned that the Russell 2000 may face limited upside in the first half of 2026. They cite potential interest rate pressures and historical trading patterns as factors that could constrain gains after the initial January surge.

How to Play the Small-Cap Rally

For investors looking to participate in the small-cap renaissance, several approaches warrant consideration:

  • Broad ETFs: The iShares Russell 2000 ETF (IWM) offers diversified exposure to the small-cap universe
  • Quality Focus: ETFs that screen for profitable, higher-quality small caps may reduce risk
  • Sector Selection: Financials and industrials within the small-cap space may benefit most from the current environment
  • Active Management: With valuations more dispersed than in large caps, active stock selection could add value

The Bottom Line

The Russell 2000's surge to record highs marks a potentially significant shift in market leadership. After years of underperformance relative to mega-cap technology stocks, small caps are finally having their moment.

The catalysts are real: attractive valuations, improving earnings prospects, a more accommodative Fed, and rotation out of crowded large-cap tech positions. Whether this marks the beginning of a sustained period of small-cap outperformance or a temporary January phenomenon remains to be seen.

For investors who have been underweight small caps, the message from the market is clear: the "Great Rotation" may finally be upon us. The question is whether it's too late to join—or whether the best gains are still ahead.