Last Thursday, just one day after the Federal Reserve cut the federal funds rate (FFR), the S&P 500, Nasdaq, and Russell 2000 hit record highs.
The S&P 500 and Nasdaq gained 0.5% and 1%, respectively. But the real action was in small caps: the S&P 600 surged 2.3%, while the Russell 2000 jumped 2.5%.
The performance in small caps is an especially encouraging development for the broad market. Small caps have been one of the weakest asset classes for years – much longer than is typical in a cycle. Their participation in the current market rally improves market breadth, a key indicator of market health that occurs when more stocks participate in an upside move.
For investors with meaningful small-cap exposure, this move is particularly welcome. For those who are still underweight, it could signal an opportune moment to add exposure.
[text_ad]
Rate-Cutting Periods Have Favored Small Caps
History suggests that small caps perform well at the start of rate-cutting cycles. While there’s no guarantee the Fed will keep cutting, markets are currently pricing in a 90% chance of another cut on October 29 and a 75% chance of one on December 10.
Looking further ahead to December 2026, the market expects, with about 54% probability, that the FFR will settle between 2.75% and 3.25%, implying 100–125 basis points of cuts from current levels.
These cuts should benefit rate-sensitive areas of the small-cap universe, including financials and industrials, which carry significant weight in the index.
But we’ll need more than a couple of sectors to benefit from rate cuts for the small-cap indices to really take flight.
The real key is earnings growth. Small-cap earnings have been largely stagnant for the past two to three years, while large caps have steadily grown profits. That earnings divergence is one of the biggest reasons why large-cap stocks have outperformed and small caps have lagged. Investors reward companies that deliver profit growth.
Are Small-Cap Earnings Turning the Corner?
The chart below from Yardeni Research shows the earnings story clearly.
The red line (S&P 500 earnings) shows large-cap profits rebounding quickly after the pandemic, hitting new highs around 2024 and continuing higher since.
Meanwhile, the green line (S&P 600 earnings) shows small-cap profits remain below pre-pandemic levels. But you can see that the green line has just begun to inflect upward. This shows that analysts are beginning to forecast stronger earnings growth for small caps.
If the trends hold, small caps could start to earn their way back into investors’ portfolios, narrowing the valuation gap with large caps.
By the way, the blue line (S&P 400 mid-cap earnings) is also improving. Analysts are just now beginning to forecast that earnings for mid-cap companies will surpass their pre-pandemic highs. It should be a good time to invest in mid-caps as well.
How Are Different Market Caps Performing?
While the mega-caps and AI stocks are getting the lion’s share of attention these days, stock price performance across market caps has been surprisingly similar since the beginning of May.
Since the beginning of August, small caps have outperformed.
This suggests investors are beginning to notice the potential of smaller companies. But by no means are small caps getting too much credit. With a forward PE ratio of just 15.7, the S&P 600 Index still trades at a deep discount to the 22.6 forward PE of the S&P 500 Index.
What’s Ahead?
The Fed’s latest cut provided a timely boost to an already strong market. Historically, stocks of all sizes tend to perform well during easing cycles.
According to J.P. Morgan, the S&P 500 has gained an average of 13.7% in the first year of an easing cycle and 26.5% in the second year. This assumes no recession.
That said, the current cycle has already produced an 18% gain in its first year, fueled by AI enthusiasm and productivity growth. Some of the easy upside may already be behind us.
Still, with further cuts likely and with onshoring trends providing a structural tailwind, small-cap earnings estimates are finally moving higher. That’s good news for a segment that has lagged for years and which carries higher exposure to floating-rate debt than large caps, making it especially sensitive to lower borrowing costs.
How to Invest in Small Caps
For broad exposure, high-quality ETFs are a straightforward way to play the trend in small-cap stocks. Two I like are:
iShares S&P SmallCap 600 Core ETF (IJR) – a diversified, high-quality small-cap ETF.
Vanguard Small Cap Growth ETF (VBK) – tilted toward the growth side of small caps.
For those who prefer individual stock opportunities, my Cabot Small-Cap Confidential advisory covers some of the most promising small-cap names in the market. You can learn more, and take advantage of a special discount, by clicking here today.
[author_ad]
