As we head into the heart of the second‑quarter earnings season, small-cap stocks are doing something investors haven’t seen in quite some time: They’re leading the market higher.
Year to date, the S&P 600 SmallCap Index is up 13.3%, compared to a gain of just 4.0% for the S&P 500. Looking back, the divergence began just before Thanksgiving – around November 20 – when small caps started to pull away in earnest.
While all small-cap sectors are positive year to date, the leadership in small caps has been especially pronounced in energy (+33%), technology (+27%), and materials (+24%). Large caps are also up in those areas, but large‑cap technology has been a notable underperformer, lagging small caps by nearly 20 percentage points so far this year.
Meanwhile, the S&P 500 has been weighed down by negative year‑to‑date returns in healthcare and financials, down 4.8% and 3.9%, respectively.
For a group of stocks that spent the better part of four years in the market’s penalty box, this is a meaningful shift. Investors entered 2026 with a sense that small caps – long ignored, discounted, and overshadowed by megacaps – might finally regain their footing.
So far, that’s exactly what’s happening.
Why Are Small-Cap Stocks Moving Now?
Despite brief bursts of relative strength in 2020 and 2021, small caps have lagged large caps for much of the time since 2018. A recession that never arrived, stagnant earnings in the S&P 600, and soaring profits among mega-cap names all contributed to that gap.
But the forces that once held small caps back are now beginning to turn into tailwinds.
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Lower Interest Rates Are a Small-Cap Lifeline
Through late 2025, the Federal Reserve cut rates three times – in September, October, and December – bringing the federal funds rate down to a range of 3.5% to 3.75%.
Small-cap stocks tend to be more sensitive to interest rate moves than their large-cap counterparts. For many smaller companies that rely on floating‑rate debt, those cuts provided long‑overdue relief, helping to ease interest expense pressures and support improving earnings expectations.
Despite ongoing political friction between the Trump administration and Fed Chair Jerome Powell, market expectations continue to price in the possibility of additional easing later this year. As of yesterday, the CME FedWatch tool showed roughly a 35% probability that rates finish 2026 in a range between 3.0% and 3.5%.
Nothing here is guaranteed – but even modest declines in rates disproportionately benefit small caps. And investors are clearly paying attention.
M&A and IPO Activity Are Back
Another important piece of the puzzle is deal activity.
Dealmaking has accelerated to its highest level since 2021. According to EY, U.S. M&A transactions valued at more than $100 million were up 25% year over year by volume and 43% by value in early 2026 – a clear sign that confidence is returning as financing conditions improve. Value and volume in deals over $5 billion are up as well, by 82% and 25%, respectively.
Historically, small-cap M&A tends to pick up when financing costs fall and valuations are depressed – exactly the setup we see today. Private equity firms, strategic buyers, and cash‑rich large caps are all becoming more active again, and small caps remain their natural hunting ground.
Earnings Growth Favors the “Little Guys”
After several years of muted results, small-cap earnings growth is finally showing signs of life.
Small-cap earnings grew by 14% in 2025 and are expected to grow by 17.1% in 2026, followed by 18% in 2027 and 17.3% in 2028. By comparison, large-cap earnings grew by 12.9% in 2025 and are expected to grow by 18% in 2026, 16% in 2027, and just 10.7% in 2028.
While the small‑cap advantage is relatively narrow this year, forward earnings expectations increasingly tilt in their favor – helped by operating leverage, easing financial conditions, and greater exposure to domestic demand.
SMID‑Cap Valuations Are Still Low
Despite improving fundamentals and recent outperformance, small caps continue to trade at a meaningful discount to large caps. The forward P/E ratio for the S&P 600 currently sits at 15.9, compared to 20.8 for the S&P 500.
Historically, when small caps trade at this kind of valuation gap, forward returns for the asset class have been strong. The combination of faster expected earnings growth and discounted valuations creates a backdrop that could continue to support relative outperformance – even if the broader market remains choppy.
Where to Find the Best Small Caps
After years on the sidelines, small caps are once again showing leadership. Lower rates, improving earnings growth, rising M&A activity, and attractive relative valuations have created a setup that long‑term investors don’t see very often.
If you’re interested in identifying the companies best positioned to benefit from this shift – those with real catalysts and accelerating growth – consider a subscription to Cabot Small-Cap Confidential.
This advisory is built for moments like this. Each month, I highlight one high‑conviction small‑cap opportunity with the potential to outperform as this next phase of the small‑cap cycle unfolds.
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