The Case for Small-Cap Stocks in 2026

Small-cap stocks began their turnaround in the fourth quarter of last year and are keeping up that momentum so far in 2026. Small-cap growth stocks have gained 2.78% and small-cap value stocks have risen 9.17%, year to date.

And the outlook is promising.

There are several catalysts that can keep the performance going, including:

Sector Rotation, away from the large caps that have so dominated the marketplace into smaller names, as well as a rotation from growth to value.

Earnings Growth. Last year, corporate earnings grew about 15%; the same rate is projected for 2026. That bodes well for the stock market, as earnings generally precede share appreciation. And small caps are forecast to grow earnings by about 19% this year, which adds to their attraction.

Interest Rate Reductions. The Federal Reserve is expected to nudge rates down a couple of times in 2026, and since small-cap companies tend to be more affected by the rates on their (usually floating-rate) outstanding debt, this can reduce expenses, leading to greater earnings.

Valuation. Small caps are averaging P/E ratios of 17x, compared to the 29x the S&P 500 currently trades at.

Economy. Economic growth continues to look strong, with economists now predicting a 2.5% GDP, compared to their previous estimate of 2.1%.

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As for sectors, here is the latest evaluation from Morningstar.

Source: Morningstar.com

As you can see, currently, small-cap stocks in the real estate, communication services, and technology sectors are the most undervalued. Of course, technology, particularly large caps, has been booming, but there may be some room in the small-cap sector for gains, especially in those companies associated with artificial intelligence. Real estate—in my opinion—is not quite ready for take-off—not enough buyers and sellers right now. But I do like the opportunities in communication services.

Also, I believe there is room in 2026 for gains in the industrial and healthcare services arenas (especially healthcare).

The following graph illustrates that while certainly more volatile than their larger-cap peers, small caps do offer attractive long-term potential.

And with that in mind, here are a few ETFs (and their 10 largest holdings) in the small-cap area that you may find of interest.

3 Small-Cap Stock ETFs to Watch Now

Dimensional U.S. Small Cap ETF (DFAS): 3 Stars

Vanguard S&P Small-Cap 600 Index Fund (VIOO): 3 Stars

iShares Core S&P Small-Cap ETF (IJR): 3 Stars

To learn more about the funds I follow in Cabot Money Club, subscribe today.

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