Small Cap Success: Why This Rally Looks Different

Small cap stocks have traditionally been made up of more cyclical and old-economy stocks. Technology only accounts for 13% of the small cap universe¹ versus 37% in the S&P 500. In essence, small caps are a better reflection of confidence in the U.S. domestic economy through bank lending, local demand, wages and capital expenditure. While short bursts of small cap outperformance over the last three years have been driven by falling bond yields and investors playing catch-up, those gains quickly faded.

This market move feels different. Led by a fundamental improvement in earnings, it shows a broadening of the AI trade across both sector and scale. This is especially important for investors who share a more optimistic view of the U.S. economy, even in the face of worries around an economy that can run too hot.

Squaring Rate-Hike Expectations

Expectations of rate cuts have traditionally boosted small caps, thanks to lower policy rates and as a result, lower interest expense. A series of rate cuts in the fall of 2025 brought the federal funds rate to 3.50–3.75%, a move that signals a desire to support growth and can push investors to pursue smaller or riskier companies. 

Naturally, this spurs economic growth. But for small cap stocks especially, every cut can be an immediate boost to earnings. Unlike large cap companies that are mostly locked into low-cost, long-term fixed bonds, a large portion of small cap stocks remain exposed to floating-rate debt. As a result, even modest changes in short-term rates can have an outsized impact on earnings.

But investors are now pricing in one to two rate hikes by the end of the year. So why are small cap stocks rallying in the face of a potential headwind?

For starters, the magnitude of interest-rate changes being priced into financial markets is less than it has been in previous hiking cycles. Any potential move would be more digestible now than it has been in the past, which creates room for investors to appreciate both their valuations and earnings.

Starting with valuations, small caps as a whole trade at a ~20% discount to their large cap peers. The discount on a 10-year average is 9.8%. But it’s the group’s earnings expectations that are more notable. After several years of rangebound estimates, they inflected sharply higher in mid-2025 and continue to be revised upward this year. That’s thanks to lower interest rates, a domestic capital expenditure boom and moderating input costs. Consensus earnings growth estimates for the Small Cap 600 Index now stand at an annual rate of 15% for the next two years. 

The physical AI build-out, fiscal stimulus, thinner margins and higher fixed-cost bases give small caps far greater operating leverage than their large cap peers – even if a modest pickup in U.S. domestic demand occurs. As a result, wages, local spending and business investment flow through disproportionately to their bottom line. That can turn incremental economic strength into outsized earnings upside precisely because they are not companies of scale.

The Broadening Has Legs

For years, investors waiting for a broader market rally have been repeatedly disappointed as market leadership narrowed and mega-cap technology companies dominated returns. But the baton is beginning to pass. While AI remains a powerful theme and continues to power large cap indexes higher, investors no longer have to rely on a handful of winners. Rather, the tech-powered gains could lead to more market breadth. That means investors may no longer need to choose between the mega-cap AI story and the rest of corporate America, but rather see stocks across market caps rally in tandem.