When Small Caps Outpace the Giants

To navigate markets is to read the wind and trust the compass, not simply the chart. In the world of equities, small-cap stocks often sail like nimble vessels, quick to adjust course and catch subtle currents that leviathans—the large-cap giants—cannot. This year, as those giants pause and investors scan the horizon for new leadership, it is the smaller, overlooked ships that have begun to surge, charting a fresh path toward value and growth.

Market history offers several chapters highlighting small-cap resurgence. In the 1990s’ bull run, small caps delivered outsized returns during technology's first expansion before giving way to blue-chip dominance. In the wake of the 2008 financial crisis, many small firms led the early recovery, leveraging flexibility and regional focus as the economy healed. Most recently, the post-pandemic rebound of 2020 saw the Russell 2000 index surge nearly 100% from the March lows as policy stimulus and rate cuts drove a frantic catch-up rally. The lesson: when the macro climate shifts—be it via rates, policy, or structural change—these market “smalls” often chart ahead of the fleet before the rest can even set sail.

Fast-forward to 2025 and the tide has clearly turned. After trailing for much of the past decade, small caps have accelerated sharply since midyear. The Russell 2000 recently hit a new all-time high, surpassing even its November 2024 record, buoyed by investor anticipation of Federal Reserve rate cuts and new pro-growth policies from Washington. Over the last three months, the iShares Russell 2000 ETF returned 15%, topping the iShares Russell 1000’s 10% gain. Though so far this year, large caps still lead (S&P 500 up 8.7% vs. 1.6% for small caps), the recent trend signals a growing rotation into smaller names.

Why this pivot? Several factors stand out. First, small caps are typically heavier borrowers with floating-rate debt, meaning any easing from the Fed cuts financing costs and boosts earnings. Second, their domestic focus—less exposed to global trade and political turbulence—has insulated them from tariff crosswinds and positioned them to benefit from U.S.-centric fiscal stimulus.

Beneath the headlines, the most compelling argument for small caps isn’t just price action—it’s price. Compared to their large-cap peers, small-cap stocks today are trading at some of the widest valuation discounts seen since the 1990s. The average price-to-book (P/B) for the S&P 500 sits at 5.0, while the Russell 2000 languishes at just 1.8. Some broad indices indicate even greater divergence, with large caps at 5.35x and small caps at 2.03x book value. These spreads suggest untapped potential for multiple expansion, especially as small businesses stand to benefit most from tax cuts and infrastructure programs.

Examples abound. Infrastructure-oriented small caps like Badger Infrastructure Solutions have reported double-digit growth and launched ambitious share buybacks despite volatile conditions. In the tech space, semiconductor suppliers Astera and Credo have posted triple-digit price gains and are now key contributors to index returns. Meanwhile, a fresh crop of niche-AI players—including C3.ai and SoundHound AI—continue to disrupt their fields with specialized solutions for cloud, enterprise, and automotive markets.

These names provide both ballast and sail—grit in balance sheets and imagination in business models, even as the overall sector remains more volatile than its large-cap cousins.

No journey is without risk. Small caps demand vigilance from those at the helm. Liquidity remains thin—large trades can move prices quickly, and bid-ask spreads widen during bouts of market stress. Volatility, too, is higher: intra-day swings of 1.5–2% are not uncommon, far greater than the typical 0.5–1% range for large caps. Perhaps most crucial, financing risk lingers; more leverage and higher refinancing costs could test weaker balance sheets as monetary policy evolves. Stock-picking matters more than ever, particularly as the sector harbors both tomorrow’s leaders and today’s laggards.

For investors, small caps are less a map than a compass—a way to orient, not dictate, a portfolio’s journey. The current rally signals renewed faith in the lifeblood of America’s entrepreneurial economy, where risk and reward are most closely linked. As monetary and fiscal winds shift, expect both turbulence and opportunity.

Independent Thinking. Steady direction.