US small-cap stocks are staging a notable comeback in 2026, outperforming their large-cap peers after years of lagging returns, as sector dynamics, valuation resets, and improving earnings prospects reshape market leadership.

So far this year, small caps have outperformed large caps by 8.5 percentage points, marking a sharp reversal after roughly six years of underperformance.

The shift comes amid broader changes in investor positioning, with capital rotating away from large technology stocks and toward more cyclical and undervalued segments of the market.

The S&P SmallCap 600 Index has gained 6.8% in the year so far, while the S&P 500 in the same time is down 0.49%.

Sector dynamics tilt in favor of small caps

A key driver of the outperformance has been sector composition. Energy, the best-performing sector this year, carries a larger weight in small-cap indices than in large-cap benchmarks.

It accounts for 6.5% of the S&P 600 small-cap index compared with 3.5% in the S&P 500.

Smaller energy companies have also proven more sensitive to rising oil prices, amplifying gains. While large-cap energy stocks are up 29% this year, small-cap energy names have surged 41%, highlighting their higher operational leverage to commodity price movements.

At the same time, technology — a dominant sector in large-cap indices — has underperformed.

Information technology makes up roughly a third of the S&P 500 but only 12% of the S&P 600.

The relative weakness in tech, partly linked to concerns around artificial intelligence valuations, has weighed more heavily on large caps.

Despite this, small-cap technology stocks have delivered strong returns, creating an unusual divergence.

Even excluding the so-called “Magnificent 7” megacap tech stocks, small caps continue to outperform, suggesting that broader structural factors are at play beyond sector allocation alone.

Earnings cycle and capital spending boost outlook

Improving earnings momentum is another critical factor supporting small-cap performance.

Smaller companies are benefiting from what many investors see as the early stages of a multi-year earnings cycle, driven by capital spending, productivity gains, and reshoring trends.

Francis Gannon, co-chief investment officer and managing director at Royce Investment Partners, said in a BNN Bloomberg report, “Small caps have outperformed quite nicely over the past year. If you go back a year ago, it was right when the market bottomed around the tariff tantrum, if you will, on April 8 of last year. So the one-year number has been quite strong.”

He added, “That being said, we continue to believe small caps are at the beginning of what will be a prolonged period of outperformance, driven by what we think will be a very strong earnings cycle.”

Productivity improvements linked to artificial intelligence adoption, alongside increased domestic investment, are contributing to margin expansion for smaller firms. Policy support has also played a role, with tax incentives encouraging capital expenditure.

Gannon highlighted the importance of these trends, noting, “It’s productivity coming from AI adoption, but also when you look at the different factors driving small-cap earnings, it could be everything from AI and productivity gains to margin improvements, as well as reshoring.”

He further emphasized the strength of the investment cycle, stating, “The CapEx story is a really powerful one. In the ‘One Big, Beautiful Bill’ signed into law last year, you saw 100 per cent depreciation on capital expenditures as well as research. That’s starting what we think will be a strong CapEx cycle, and we expect that to continue.”

Valuations, rotation and market structure support gains

Valuation dynamics are also playing a significant role. Small-cap stocks tend to trade at lower multiples than large caps, and this discount has attracted investors seeking opportunities outside crowded megacap trades.

The rotation away from large technology stocks has further supported smaller companies. As investors diversify portfolios and reduce concentration risk, capital has increasingly flowed into under-owned segments of the market.

Gannon pointed to this shift, saying, “Part of the case for small caps is that rotation away from those areas. We’re seeing a broadening of the market.”

He added, “Small caps are also cheaper on a valuation basis than large caps, even after the gains over the past year. Combine that with what we see as the start of a prolonged earnings cycle, and it creates a compelling story.”

The composition of small-cap indices is also evolving. While a significant portion of smaller companies remain unprofitable, the market is increasingly favoring higher-quality firms with strong earnings and cash flow.

Gannon noted, “The way we invest is in companies with earnings, cash flow, and strong fundamentals.”

This shift toward quality, combined with improving fundamentals and favorable macro trends, has strengthened the case for continued small-cap outperformance.

As markets adjust to changing economic conditions and evolving sector leadership, small-cap stocks appear to be benefiting from a confluence of cyclical and structural tailwinds — positioning them as a key area of focus for investors in the current environment.

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