You can’t blame investors for a bit of giddiness. The S&P 500 is on pace to notch its second consecutive year with returns above 20%, and with the index hitting all-time highs, many investors' account balances are similarly skyrocketing.
There have been have’s and have-nots, though. Much of the return is because of seemingly insatiable interest in the so-called Magnificent Seven stocks, a group of large-cap technology stocks comprising the likes of Alphabet, Microsoft, and Apple.
Smaller companies with lower market capitalization haven’t performed nearly as well.
Granted, they’re still up, and some are by a lot. But, the Russell 2000 small-cap index of stocks is up “just” 16%, a far cry from the gaudy Nasdaq 100 return of 31%.
Small-cap stocks’ streak of underperformance has left some wondering whether things will likely improve. Interest in small-cap stocks has been climbing lately, and we’re fast approaching the time of year when they tend to shine—something commonly called the January Effect.
Donald Trump’s election as president hasn’t hurt small-cap stocks, either. Many of Trump’s policies embrace an ‘America First’ narrative. Russell 2000 companies derive nearly 80% of revenue from domestic operations, and Trump’s antitrade stance and focus on dollar dominance have started to boost investor sentiment toward the group.
The Russell 2000 small-cap stock index has lagged the performance of the large-cap S&P 500, prompting analysts to revamp outlooks.Michael M. Santiago/Getty Images
Small-cap stocks are closing the gap to large-cap stocks
Over the past few years and throughout market history, there have been periods when small-cap stocks performed better than large-cap stocks. However, for the most part, it has paid to overweight large-cap versus small-cap stocks over the past decade or so.
For example, over the past 10 years (through December 13, 2024), the S&P 500 has almost doubled the return of the Russell 2000 small cap index (200.8% versus 103.2%). More recently, on a year-to-date basis, the S&P 500 has advanced 27.1% versus a gain of 16.1% for small-cap stocks.
However, since the November 5, 2024 election, the S&P 500 has gained 6.0% versus 5.9% for small-cap stocks (all based on the performance of the Russell 2000 ETF (IWM) and S&P 500 ETF (SPY) - using total return through December 13, 2024).
Small-cap earnings outlook is improving
Large-cap stocks have outperformed small-cap stocks in recent years because large-cap stocks have generated more robust EPS growth than smaller companies. Over time, stocks tend to follow the direction of corporate profits.
Two contributing factors to the S&P 500’s earnings outperformance are its 31% technology exposure, tilted heavily toward the biggest, most established technology leaders, versus just 14% for the Russell 2000 Index, and the fact that about 35% of the Russell 2000 is currently unprofitable, versus a much smaller percentage for large-cap stocks.
However, things may be about to change on the earnings front.
Looking ahead, S&P 500 stocks are currently forecast to generate 13% EPS growth in 2025 and 13.1% growth in 2026 (versus 8.5% EPS growth in 2025), while the S&P SmallCap 600 Index is currently forecast to generate EPS growth of 20.9% in 2025 and 18.6% EPS growth in 2026 (versus minus 8.0% EPS growth in 2024), according to CFRA.
If EPS data comes close to matching these estimates, it should represent a favorable tailwind for small-cap stocks in the period ahead.
When has it made sense to buy small-cap stocks?
At least historically, the time to overweight small-cap stocks has been when the economy is coming out of recession, credit markets are wide but improving, growth is weak but picking up, and there’s more of a risk-on appetite in global financial markets.
While the Federal Reserve recently started a new rate-cutting cycle, credit spreads (i.e., the difference between the spread on high-yield bonds and U.S. Treasury Bonds) are currently at the tightest level in over a decade. Economic growth has been reasonably strong over the past few years, and you could make the case that there has already been a risk to the environment in financial markets over the past few quarters.
One clue regarding the performance of small-cap stocks in 2025 may be the NFIB Small Business Optimism Index.
Last month, in the first report for this index following the recent presidential election, the index jumped 8 points to 101.7 and rose above its 50-year average for the first time in almost three years.
According to the NFIB’s chief economist, Bill Dunkelberg, “The election results signal a major shift in economic policy, leading to a surge in optimism among small business owners.” If this trend continues, it should bode well for a pickup in small business growth and the outlook for small-cap stocks in the year ahead.
Are small-cap stocks cheap?
Typically, investors look at valuation levels for various stock market indices in two ways: absolute value and relative value. On an absolute basis, the S&P 500 and Russell 2000 small-cap indices are trading above their historical valuation levels. However, on a relative basis, things look different.
According to recent data from Merrill Lynch, the Russell 2000 Small Cap Index currently trades at a relative P/E ratio of 0.78x that of the large-cap Russell 1000 Index. While this is up from a recent level of 0.73x, it is still about 20% below the historical average of 1.0x.
Based on research data from CFRA, the S&P 500 is currently trading at 22.9x forward 12-month EPS estimates versus a 10-year average of 19.0x, while the Small 600 Small Cap Index (another small cap index that is higher quality than the Russell 2000 Index) is currently trading at 18.1x forward 12-month EPS estimates versus a 10-year average of 18.7x.
Again, looking at things on a relative P/E basis, the S&P 600 Small Cap Index currently trades at .79x that of the S&P 500 Large Cap Index versus a 10-year average of .98x (similar to data for the Russell 2000 Index highlighted above).
Are small-cap stock balance sheets on sound financial footing?
In addition to looking at differences in valuation levels and historical market returns, there is also a significant difference when you look at the financial health of small-cap versus large-cap stocks. Specifically, when you look at financial health and overall stability, large-cap stocks currently have the edge versus small-cap stocks for the following reasons:
Stronger balance sheets: on average, large-cap stocks have lower debt / EBITDA ratios (which indicates less debt to a company’s cash flow…..and reduced financial risk)
More fixed-rate debt and less floating-rate debt: large-cap companies did a better job locking in less expensive fixed-rate debt when the Fed started raising rates last cycle….which should provide greater financial stability
Less bond maturities coming due over the next 5 years: fewer bond maturities mean less need to raise funds for upcoming bond maturities and should also provide companies with greater financial stability
Profitability: A much greater percentage of companies in the S&P 500 are currently profitable compared with the Russell 2000 small-cap index
Are small-cap stocks more volatile than large-cap stocks?
Another factor to consider is volatility. This can be measured differently, but let's look at two factors - beta and market drawdown.
Over the past year, the beta (i.e., the level of market movement versus an underlying index) has been 1.48x. The Russell 2000 Index (using the IWM ETF as a proxy) is about 1.5x as volatile as the broader large-cap S&P 500.
Another way to look at volatility is by market drawdowns over a specific period. Over the past 10 years, the largest market drawdown for the Russell 2000 Index (again using the IWM ETF as a proxy) has been 41.1% compared with 33.7% for the large-cap S&P 500. This indicates that investors looking to reduce volatility may want to favor the large-cap S&P 500 compared with the small-cap Russell 2000 Index.
The Impact of a Strong Dollar on small-cap stocks
If Trump's policies lead to more substantial growth in the U.S. and the dollar rebounds further, U.S. companies that derive a majority of their sales from the U.S. could benefit more in 2025.
For reference, companies in the Russell 2000 small-cap index currently generate 21% of sales overseas compared to 28% for the large-cap S&P 500, 46% for the tech-heavy Nasdaq 100 Index, and 49% for the Mag 7 companies (source: Goldman Sachs).
Are small-cap stocks buys?
When you put it all together, small-cap stocks should perform better in the year ahead if the economy generates a pick-up in growth, animal spirits emerge, corporate profits meet expectations, and we experience more risk-on tone in financial markets.
Valuation levels for small-cap stocks are not cheap on an absolute basis but are relatively attractive compared to the large-cap S&P 500 stock market Index. Lastly, keep in mind that, at least historically, small-cap stocks have been more volatile, have weaker balance sheets, and have experienced larger drawdowns during periods of market volatility.
What Wall Street pros say about small-cap stocks?
Wall Street has a wide range of opinions regarding which areas of the market will be market leaders in 2025.
Piper Sandler is one Wall Street firm bullish on small-cap stocks next year. In its 2025 outlook, the firm highlighted, "Historically, the SPX (S&P 500) has averaged 5.2% in the third year of a bull market. At the same time, SMID-caps often return double-digit returns as the market broadens out.”
The firm’s technical analyst Craig Johnson added, “After two consecutive years of over 20% gains in the SPX (Large-cap stock), Small- and Mid-cap (SMID-cap) stocks have started to gain momentum. This trend began in July and is poised to accelerate through 2025."
Fundstrat’s Tom Lee is another small-cap stocks bull. In November, Lee told CNBC that Donald Trump’s election could mean that small-cap stocks outperform large-cap stocks by 100% over the coming couple of years. Previously, he said that small-cap stocks were in the process of making a multiyear bottom.
