Two weeks into 2026, small and mid‑cap (SMID) stocks are doing something investors haven’t seen in years: leading the market higher.
The S&P 600 is up 5.3% and the S&P 400 is up 4.9%, while the S&P 500 has gained just 1.9%. Perhaps most impressive is the Russell 2000, which has just logged its longest streak of relative outperformance against the S&P 500 since 2019 – an 11‑month run that began in February 2025.
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 SMID caps – ignored, discounted, and overshadowed by mega‑caps – might finally reclaim the podium.
So far, that’s exactly what’s happening.
Why Now? A Reversal Years in the Making
Despite brief bursts of strength in 2020 and 2021, SMID caps have lagged large caps since 2018. A recession that never arrived, flat earnings in the S&P 600 and S&P 400, and soaring profits in the S&P 500 all contributed to the divergence.
But the forces that once held SMIDs back are now turning into tailwinds.
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Lower Interest Rates Are a Lifeline
Through late 2025, the Federal Reserve cut rates three times – in September, October, and December – bringing the federal funds rate down to 3.5% - 3.75%. For thousands of small companies that rely on floating‑rate debt, these cuts are long‑overdue relief.
And despite political noise between the Trump administration and Fed Chair Jerome Powell, markets still expect one to three more cuts in 2026. As of yesterday, the CME FedWatch tool showed an 81% probability that rates end the year between 2.75% and 3.5%.
Lower rates disproportionately benefit SMIDs, and investors know it.
M&A and IPO Activity Are Back
Deal‑making has surged to its highest level since 2021. Small-cap M&A historically accelerates when financing costs fall and valuations are depressed – exactly the setup we see today. Private equity, strategic acquirers, and cash‑rich large caps are all active again, and SMIDs are the natural hunting ground.
Earnings Growth Favors the “Forgotten Middle”
Analysts expect small-cap earnings to grow 15% in 2026 and mid‑cap earnings to grow 19.3%, both ahead of the 14.8% expected for large caps. After years of flatlining, SMID earnings are finally inflecting upward.
SMID‑Cap Valuations Are Still Low
Despite improving fundamentals, SMIDs remain deeply discounted:
- S&P 600 forward P/E: 15.9
- S&P 400 forward P/E: 16.5
- S&P 500 forward P/E: 22.1
Historically, when small caps trade at this kind of discount, forward returns are strong. In other words: The most hated corner of the market is finally turning – and it’s still cheap.
The 2026 Small‑Cap Playbook: Four Sectors with Real Tailwinds
Given the trends, where should investors look to put money to work in the SMID‑cap universe?
1. Regional Banks: A Rate‑Cut Winner
Smaller regional banks have several meaningful catalysts working in their favor. Additional Fed rate cuts would immediately reduce funding costs, while steady loan growth continues to support top‑line momentum. The possibility of deregulation – such as lifting the Category IV $100B threshold – adds another potential tailwind, and rising M&A activity is already creating a more supportive valuation backdrop.
2. Industrials: Riding the Capex Supercycle
Industrial‑exposed small caps should thrive as several powerful investment cycles converge, including U.S. infrastructure upgrades, hyperscale data‑center spending, reshoring and supply‑chain diversification, and accelerating adoption of automation and robotics. Many industrial SMID‑cap companies enter 2026 with leaner cost structures, improving margins, and healthy order books, an unusually strong setup for a sector that typically benefits later in the economic cycle.
3. Gold and Gold Miners: A Hedge for a Volatile World
Macro uncertainty remains high – geopolitics, inflation variability, and policy unpredictability all support elevated gold prices. Small and mid‑cap miners offer leveraged exposure to this trend.
4. Biotechnology: M&A Fuel and Regulatory Clarity
Biotech is historically one of the most rate‑sensitive corners of the market. Lower rates boost risk appetite and ease financing conditions, while rising M&A appetite from large pharma adds a second tailwind. Many small-cap biotechs are transitioning from clinical‑stage to commercial‑stage, often with net cash on the balance sheet, first revenue inflection points, and pipelines that look increasingly attractive to acquirers. Add in an FDA that is meeting approval timelines and a clearer regulatory environment, and 2026 looks unusually promising.
Why You Can’t Afford to Ignore SMID Caps
After years of being ignored, discounted, and overshadowed, SMID caps are finally showing leadership.
More importantly, the underlying fundamentals support the move. Lower rates, accelerating earnings, rising M&A, and cheap relative valuations create a setup that long‑term investors rarely see.
This is exactly the environment where individual small-cap stock selection really matters.
If you want to identify 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 service is built for this moment. Each month, I spotlight one high‑conviction small‑cap opportunity with the potential to outperform as this new SMID‑cap cycle unfolds.
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