Small Caps Lead 2026 as Russell 2000 Jumps 5.8% YTD
The Russell 2000 is off to its best start in a decade. Lower rates, cheap valuations, and fiscal tailwinds drive the rotation from mega-caps.
The small-cap trade is finally working.
The Russell 2000 has gained 5.8% in the first three weeks of 2026, marking its strongest start to a year since 2013. That compares to 2.1% for the S&P 500 and 1.8% for the Nasdaq Composite over the same period. After years of underperformance, investors are rotating into the unloved corner of the equity market.
The iShares Russell 2000 ETF (IWM) broke above $250 last week for the first time, with volume running 35% above the 20-day average. This isn't a one-day blip—money has been flowing into small-cap funds for six consecutive weeks according to EPFR data.
Why Now?
The setup has been building for months. By late 2025, small caps traded at an 8-point P/E discount to large caps—the widest gap in 25 years. The Russell 2000 forward multiple sat near 18x versus 26x for the S&P 500. Value investors had been pounding the table, but the trade needed a catalyst.
Three things changed:
Rate cuts arrived. The Fed's three consecutive 25-basis-point cuts brought the federal funds rate to 3.50-3.75%. Small-cap companies carry more floating-rate debt than their large-cap peers, making them disproportionate beneficiaries of lower borrowing costs. The average Russell 2000 company saw interest expense fall 12% sequentially in Q3 2025.
Fiscal policy helped. The "One Big Beautiful Act" passed in July 2025 locked in 21% corporate tax rates and—more importantly for capital-intensive businesses—restored 100% bonus depreciation. Small manufacturers and industrials can now expense equipment purchases immediately rather than spreading them over years.
Earnings are accelerating. Consensus estimates project 17-22% earnings growth for the Russell 2000 in 2026, compared to 14% for the S&P 500. That's the first time in years that small-cap profit growth is forecast to outpace large-cap.
The Mega-Cap Problem
The flip side of small-cap strength has been large-cap weakness—specifically in the mega-cap tech names that dominated returns from 2020 through 2025.
Apple is flat on the year after Raymond James downgraded the stock in early January, citing "limited upside at current valuations." Nvidia has pulled back 8% from December highs as some investors question whether AI spending can continue at the current pace. Microsoft, Amazon, and Meta are all underperforming the broader market.
This isn't necessarily bearish for tech. It's more that the valuation gaps had become so extreme that mean reversion became inevitable. When seven stocks account for 30% of the S&P 500's market cap, even modest rotation can move the small-cap needle significantly.
Sector Leadership
Within small caps, financials and industrials are leading. Regional banks benefit directly from the steeper yield curve and less restrictive Fed policy. Industrial companies—particularly those with domestic manufacturing exposure—are seeing order books strengthen as reshoring trends accelerate.
Healthcare has lagged despite being a traditional small-cap overweight. Biotech volatility and uncertain FDA policy under the new administration have kept investors cautious. That could change if the IPO window opens later this year, but for now, money is flowing elsewhere.
Energy small caps have been mixed. Oil prices have stabilized in the mid-$70s, which is profitable for most producers but not exciting enough to drive multiple expansion. Natural gas names have done better as winter demand picked up.
Can It Last?
Goldman Sachs projects a 12% return for the Russell 2000 for full-year 2026—roughly matching their S&P 500 target. In other words, the early outperformance may not persist through December.
The historical pattern supports that view. Small caps tend to outperform in the first half of Fed cutting cycles, then give back ground as large-cap growth reasserts itself. The question is whether this cycle follows the template.
Two factors could extend the trade:
Valuation room remains. Even after the January rally, small caps trade at an 18% discount to large caps on forward earnings. The long-term average is roughly equal valuations. If mean reversion continues, there's another 15-20% of relative upside before the trade gets crowded.
Breadth is improving. Market participation has been historically narrow for three years. The percentage of Russell 2000 stocks above their 200-day moving average hit 68% last week—the highest reading since March 2024. Healthy bull markets feature broad participation.
The counter-argument is straightforward: if economic growth disappoints, small caps will get hit harder than large caps. They always do. The companies are more leveraged, more cyclical, and more exposed to domestic demand. A hard landing scenario—even if unlikely—would crush the trade.
For now, momentum favors the little guys. The first three weeks of 2026 have rewarded those who bought the valuation discount. The test will be whether that discipline holds when the next growth scare arrives.