For the better part of five years, investing in the stock market has meant one thing: buying the biggest technology companies and watching them grow ever larger. The "Magnificent Seven" and their mega-cap peers have dominated returns, captured headlines, and left smaller companies in their considerable shadow.

But something shifted in late 2025. The Russell 2000, the benchmark index tracking America's small-cap stocks, broke out to record highs in early December, with the iShares Russell 2000 ETF (IWM) hitting an all-time closing price of $251.82. After years of underperformance, small caps are suddenly outpacing their larger rivals—and many believe this is just the beginning.

The Numbers Tell the Story

The Russell 2000 has delivered a total return of approximately 15% in 2025, a solid performance by historical standards. But the real action has been in recent months: over the past six months, the small-cap benchmark has surged nearly 19%, significantly outpacing the S&P 500's 11% gain during the same period.

After a brutal 20.4% loss in 2022, small caps have staged a methodical comeback—up 16.9% in 2023, 11.5% in 2024, and now accelerating into year-end 2025. The pattern suggests a fundamental shift in market leadership, not just a temporary rotation.

"What we're witnessing is the beginning of an earnings handoff from mega-cap tech to the rest of the market. Small caps have been neglected for years, but their fundamentals are improving dramatically."

— Michelle Park, Small-Cap Strategist, T. Rowe Price

The Earnings Handoff

The most compelling argument for small-cap outperformance lies in the diverging earnings trajectories. Consensus estimates project Russell 2000 earnings per share growth of 44% in 2025—a staggering figure that dwarfs the slowing growth seen in large-cap indices.

Looking ahead to 2026, FactSet estimates project small-cap profits to grow approximately 22%, significantly higher than the 15% forecast for large caps. This "earnings handoff" represents a fundamental shift in where corporate America is generating incremental growth.

Crucially, the earnings revision picture has flipped. For the first time in years, upward revisions now outpace downward cuts in the Russell 2000, reflecting stronger management commentary and more frequent upside surprises during earnings season.

Small Cap vs. Large Cap: 2026 Growth Projections

  • Russell 2000 EPS Growth: +22% (2026 estimate)
  • S&P 500 EPS Growth: +15% (2026 estimate)
  • Valuation Gap: Widest in 25 years favoring small caps
  • Revision Trend: Small caps seeing net upward revisions

Valuations at Historic Lows

Perhaps the most striking feature of the small-cap opportunity is valuation. By late 2025, the Russell 2000 traded at its lowest level relative to the large-cap Russell 1000 in nearly 25 years. On an enterprise-value-to-sales basis, small caps offer a substantial discount to their larger counterparts.

This valuation gap has become so extreme that it's attracting attention from value investors and contrarians who typically focus on individual stock selection rather than broad market bets. When an entire asset class trades at multi-decade discounts while simultaneously accelerating earnings growth, it's the kind of setup that historically precedes extended outperformance cycles.

The Rate Cut Catalyst

Small-cap companies are inherently more sensitive to interest rates than their large-cap peers. They tend to carry more floating-rate debt, have less access to capital markets, and often depend on bank lending for growth financing. When rates rise, small caps suffer disproportionately; when rates fall, they benefit more than larger companies.

The Federal Reserve's pivot toward rate cuts in 2024, continuing into 2025, has provided a tailwind that small-cap investors believe will persist. Even with the Fed signaling a slower pace of cuts for 2026, the direction of travel remains favorable for smaller companies with refinancing needs.

Risks and Contrarian Signals

Not everyone is convinced the small-cap rally has legs. One notable warning sign: short interest in Russell 2000 stocks has climbed to approximately 5.5% of market cap, the highest among major indices. In other words, even as small caps hit record highs, many investors are betting heavily against them.

This contrarian positioning creates potential for volatility in both directions. Short squeezes could amplify rallies if negative bets prove wrong, but heavy short interest also reflects genuine concerns about small-cap vulnerabilities—from economic sensitivity to financing risks to the quality issues that plague some smaller companies.

Key Risks to Monitor

  • Economic Slowdown: Small caps are more cyclically sensitive than large caps
  • Financing Costs: If rate cuts disappoint, refinancing pressures could mount
  • Quality Concerns: Not all small caps are created equal; selectivity matters
  • Short Interest: Heavy bearish bets could amplify volatility

How to Play the Rotation

For investors looking to add small-cap exposure, several approaches merit consideration. Broad index funds like the iShares Russell 2000 ETF (IWM) or Vanguard Small-Cap Index Fund (VB) offer diversified exposure at low cost. Those seeking higher-quality small caps might consider the iShares Russell 2000 Growth ETF (IWO) or actively managed funds with strong track records in the space.

Value-oriented investors might look at the iShares Russell 2000 Value ETF (IWN), which tilts toward cheaper, more cyclically sensitive names that could benefit most from continued economic expansion.

The Verdict

After years of mega-cap dominance, the market appears to be rotating toward a more balanced participation. Small caps offer compelling valuations, accelerating earnings growth, and beneficial exposure to Fed rate cuts. The record highs reached in December 2025 may prove to be just the opening act of a multi-year small-cap cycle.

Of course, markets have a way of confounding consensus expectations. If the economy stumbles or rate cuts fail to materialize, small caps could give back recent gains quickly. Investors should size positions appropriately and maintain diversification across market caps.

But for those with a longer time horizon and tolerance for volatility, the small-cap opportunity looks as attractive as it has in a generation. Sometimes the best investments are the ones hiding in plain sight—and right now, that's exactly where small caps have been.