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Written by: Jimmy Topping | Advisor Asset Management
Small-cap stocks appear well-positioned for a potential turnaround as we move through the rest of the year and into 2026. Despite being in a secular bear market, the outlook is becoming increasingly favorable, with earnings for small-cap companies projected to grow by 21% in 2025 and 34% in 20261, far outpacing their large-cap peers. At the same time, valuations remain historically depressed, creating a compelling combination of strong earnings potential and attractive entry points. Historically, periods of significant underperformance in small caps have often preceded sharp, sustained rebounds. This dynamic suggests that small caps may be on the cusp of a meaningful recovery, offering investors a rare opportunity to position ahead of a potential regime shift in market leadership.
Longest Secular Bear Market on Record
The secular bear market in small-cap equities that we are currently in has persisted for over a decade, marked by consistent outperformance from large-caps. Typically, relative performance cycles last around 6.5 years, yet we are now in the 14th year of large-cap dominance, an extreme divergence that historically signals a potential reversal.2 Several macroeconomic factors could act as catalysts for a resurgence in small caps. The Federal Reserve is currently expected to implement two rate cuts this year, followed by two more in the next. Given that small-cap companies generally carry more short-term debt, they are well-positioned to benefit from lower refinancing costs, which could significantly boost earnings. Also, the small-cap space as evidenced by the Russell 2000, derives nearly 80% of its revenue from domestic operations vs. 60% for the S&P 5003 which could provide a defensive edge amid rising trade tensions and geopolitical instability, potentially serving as an additional tailwind.
Past performance is not indicative of future results.
Valuations
Valuations within the Russell 2000 have diverged notably over the past few years. Since peaking in 2020, the index’s next 12 months (NTM) price-to-earnings (P/E) ratio has steadily declined and now sits roughly one standard deviation below its historical average. 4
Past performance is not indicative of future results.
From a relative standpoint, small caps are trading at a substantial discount, approximately 40% cheaper compared to their mid- and large-cap counterparts. This level of undervaluation is rare and has historically presented compelling entry points for long-term investors.5
Sales and Earnings Growth
Looking ahead, earnings per share growth for companies within the Russell 2000 are projected to experience significant acceleration over the next two years, reflecting improved profitability, operational efficiency, and favorable macroeconomic tailwinds. This anticipated earnings growth not only underscores the fundamental strength building within the small-cap segment but also creates a strong foundation for potential outperformance in equity returns. As profit margins expand and top-line revenue growth stabilizes, investors could see a powerful re-rating in valuations, particularly given how deeply discounted the index remains relative to its historical averages and large-cap peers. In this environment, we believe small caps may present one of the most compelling growth opportunities in the equity market.
Past performance is not indicative of future results.
Additionally, when evaluated through a long-term lens using cyclically adjusted price-to-earnings (CAPE) ratios, small caps appear poised to potentially outperform large caps over the coming decade. This suggests that small caps could not only offer near-term upside but also present a durable opportunity for long-horizon investors seeking attractive relative value and earnings-driven growth. 6
Conclusion
After years of underperformance and compressed valuations, small-cap equities appear poised for a meaningful resurgence. With the Russell 2000 trading at a significant discount relative to historical norms and their mid- and large-cap peers, we think investors have a rare opportunity to enter the market at attractive price points. Projected earnings growth, combined with favorable macroeconomic shifts, such as potential interest rate cuts and a stronger domestic backdrop, further enhances the case for small-cap strength. Historically, periods of extreme pessimism in this asset class have often been followed by outsized returns. As such, small caps may represent not only a value opportunity but also a strategic allocation for long-term growth in a changing market landscape.
Related: Are These 5 Must-Watch Stocks Living Up to the Hype in 2025?
Sources:
- FactSet Research
- Ned Davis Research
- FactSet Research
- Strategas Research
- https://www.researchaffiliates.com/content/dam/ra/publications/pdf/1075-small-caps-big-opportunities-investing-beyond-large-cap-stocks.pdf
- https://riverwaterpartners.com/2025/04/11/q1-2025-small-cap-market-update-pinching-pennies-2-2/