- Valuation and index weight catch up. Small/mid cap valuations are near a 25-year low relative to large caps, and the Russell 2000’s weight in the Russell 3000 remains well below its long-term average, two largely technical, non-macro dependent tailwinds that would also reduce concentration in a market increasingly dependent on a handful of mega cap names.
- Earnings and fiscal tailwinds. Small cap earnings growth is projected to outpace large cap earnings growth for the first time in years, aided by fiscal provisions that disproportionately benefit domestic, smaller companies.
- A Fed path that has, so far, not become a headwind. The Fed cut rates through late 2025 and has since paused for four consecutive meetings. No hike has materialized, and current market pricing implies only a modest chance of one this year. We track this as a factor to watch rather than a settled tailwind. Relative to current projections, a pause would therefore be a favorable outcome.
- An AI infrastructure angle that cuts both ways. Hyperscaler capex (~$725B in 2026, up 77% year over year) increasingly channels capital to domestic small/mid cap infrastructure suppliers, though the semiconductor sector’s sharp early July pullback is a reminder that AI driven leadership can reverse quickly.
On balance, we believe the weight of the evidence supports continued small and mid-cap outperformance through 2026, and we will continue to monitor Fed policy and AI capex sustainability as the two factors most likely to influence its pace.
Setting the Stage: A Long Stretch of Large Cap Dominance
U.S. equity leadership has historically cycled between large and small cap stocks in stretches of nine to fifteen years. The run from roughly 2011 through 2024 was an unusually deep and durable period of large cap supremacy. This gap widened sharply after 2022 as the AI investment boom drove a handful of mega cap technology names to extraordinary multiples.
That backdrop matters because leadership cycles tend to mean revert. Moreover, the structural drivers that suppressed small cap performance, including zero interest rates, mega cap margin expansion, a strong dollar, and the AI capex story, are rotating in ways that increasingly favor smaller, domestically focused, more cyclical businesses.
The Past Four Quarters: A Quiet Comeback Becomes a Real Rotation
The shift began under the radar. In what became a “stealth summer,” the Russell 2000 advanced roughly 7.3% in August 2025 versus a 1.5% gain for the Nasdaq 100. The catalyst was Fed Chair Jerome Powell’s August 22nd, 2025, Jackson Hole speech, which opened the door to renewed rate cuts. Smaller companies’ greater reliance on floating rate and short maturity debt makes them more sensitive to changes in funding costs than mega caps, that generally have strong balance sheets and direct capital markets access.
The fourth quarter of 2025 saw a year end large cap rally, but the relative trend had already shifted. By the first quarter of 2026 the rotation was unmistakable – the S&P 500 fell 4.3% while the Russell 2000 posted a 0.9% gain. This represented only the second time in twenty-five years that small caps have ended a down quarter for large caps in positive territory. Momentum carried into 2026, and by the second quarter small and microcaps remained at the head of the class, with the Russell 2000 up 21.5% and the Russell Microcap up 25.6%, versus 15.1% for the Russell 1000 and 10.7% for the Russell Top 50 (Table 1)- this persistence of strong performance from smaller names distinguishes a regime change from a one quarter bounce.
What’s Driving the Rotation?
We see six primary drivers that together explain the past four quarters and inform our outlook.
1. Valuation: A 25-Year Low in Relative Terms
Even after the recent rally, small and mid-caps remain extraordinarily cheap relative to large caps. Using EV/EBIT, the Russell 2000/S&P 500 ratio sits near its lowest level in more than 25 years. As of mid-2026 the S&P 500 traded at roughly 27 times earnings versus about 15.6 times forward for the S&P Small Cap 600 and roughly 18 times for the Russell 2000 – a forward discount of nearly 31%, the widest by several valuation metrics since 1999. Similarly, the relative valuation of the Russell 2000 to the Russell 1000 remains well below the average (Chart 1).
2. Federal Reserve Policy and Funding Costs
Smaller companies are more interest rate sensitive than mega caps – they carry a higher share of floating rate and short maturity debt and typically lack direct bond market access, so Fed policy changes generally reach their cost of capital faster in either direction. Data shows small caps have outperformed large caps across all one-, three-, six-, twelve-, and twenty-four-month windows following a Fed rate cut since 1990 (Chart 2), consistent with the catalyst behind last summer’s rally. The Fed cut rates through late 2025 and has since paused for four consecutive meetings. No hike has materialized to date, and current pricing does not point to a sharp increase over the next twelve months.
3. Earnings Catch Up
The mega cap earnings advantage is also narrowing. Consensus earnings estimates increasingly favor smaller companies over their large-cap peers heading into 2026 and 2027. Crucially, the advantage is not a one-year phenomenon—small-cap growth is expected to remain strong in 2027, still exceeding large-cap estimates even as the gap narrows. Taken together, the estimate trajectory supports the case that an earnings inflection, not just valuation, underpins the SMID and small-cap opportunity (Chart 3).
4. Fiscal and Policy Tailwinds
- The CHIPS and Science Act, IRA, and OBBBA (100% bonus depreciation, immediate R&D expensing, an EBITDA basis interest deduction cap) continue directing capital and tax benefit toward smaller, domestic, and more leveraged firms.
- Tariff policy, while a double-edged sword, has accelerated reshoring announcements that benefit smaller manufacturing, logistics, and industrial services firms.
5. M&A, IPO Recovery, and Broadening Breadth
M&A deal value was up year over year through the first half of 2026, and IPO activity rebounded (Table 2).
SMID and Small caps are the natural fishing pond for both: almost 95% of public company merger transactions over the past two decades have involved companies with market caps under $7 billion (Chart 4).
6. AI Capex and Semiconductors: From Concentration Headwind to Broadening Tailwind
No discussion of the small cap thesis is complete without addressing the force that suppressed it – the AI capital expenditure boom. In 2026 the four largest U.S. hyperscalers are guiding to roughly $725 billion in combined capital spending, up about 77% from 2025. The scale and physicality of the buildout is broadening the beneficiary set beyond the mega caps. The binding constraint on AI capacity has shifted from silicon to electricity and physical infrastructure. Much of that spending flows to domestic, asset heavy suppliers, including electrical contractors, cooling specialists, power equipment makers, and datacenter construction firms, many trading at roughly 10–15 times forward earnings against the low 20s multiple of the S&P 500 – the “picks and shovels” logic of owning the enablers rather than the speculative applications (Table 3).
In sum, several tailwinds are supporting this rotation, and some may persist for several quarters or even years. Table 4 provides a concise overview of the key drivers of smaller-company performance.
Is the Rotation Sustainable?
There are several observations that point to the possibility that the past four quarters represent the early phase of a longer running shift, and not a short-term phenomenon.
1. Leadership Cycles Are Long, and This Isn’t the First Attempt
Long run studies of small versus large cap leadership cycles back to 1931 show alternating regimes that typically last nine to fifteen years; the 2011–2023 large cap regime was on the longer end (Chart 5). Once leadership transitions begin, they have historically extended for the better part of a decade.
This is not the first time in the current regime that small caps have rallied on a “this time is different” narrative. Both the 2016 postelection rally and the 2020–2021 reopening trade produced sharp, short lived small cap leadership that ultimately faded – the former as the Fed moved into a hiking cycle through 2017–18, the latter as inflation forced tightening and the AI driven mega cap narrative reemerged in 2023. In both cases, the same mechanism we identify as our leading risk today, a sustained reversal in Fed policy, is what ended the rotation, not a single rate move but an extended tightening campaign in each case.
As of mid-2026, the Fed has paused for four consecutive meetings rather than continuing to cut, and no hike has yet materialized. The rotation has continued and strengthened through the pause, a constructive, if unresolved, sign that it is not solely a rate cut trade. Valuation and index weight catchup are additional supports that do not depend on the Fed’s path, though no single factor discussed in this paper should be read as sufficient on its own. A resumed, multi-hike tightening campaign, rather than an isolated hike, is the scenario that ended the prior two rallies, and we continue to watch for that possibility rather than assuming this cycle is immune to it.
The pace and starting point of any prospective tightening also look meaningfully different from 2017–18 or 2022–23. The 2017–18 cycle accelerated to four hikes in 2018 alone; 2022–23 was far more extreme, raising rates 525 basis points in sixteen months, the fastest pace in over four decades. The Fed’s June 2026 projections imply, at most, a single 25 basis point move over the next 12 months, nothing close to either prior pace. The starting point differs too – today’s 3.50–3.75% range sits near the Fed’s own long run neutral estimate of 3.1%, versus the emergency, near zero rates of 2016 and 2020–21. A modest move off a near neutral rate is a smaller risk than unwinding an extraordinary policy low.
2. Significant Catch-Up Potential in Index Weight and the Case for Reduced Concentration
At the end of June 2026, the Russell 2000 represented just 4.3% of the Russell 3000, well below its long-term average of 7.6% (Chart 6). A return to long term average weight alone implies meaningful relative outperformance for the small cap segment, before accounting for any earnings or multiple expansion.
The historical record reinforces this case. As Chart 7 illustrates, the weight of the top five S&P 500 constituents has reached extreme highs only three times in the past half-century—April 1973, March 2000, and again in September 2025—and each prior peak in mega-cap concentration coincided with a cyclical trough in small-cap relative performance. In both earlier episodes, that crowding at the top marked a large-cap cycle peak, after which market leadership broadened, and smaller names went on to meaningfully outperform. With the top five weight now at a historic extreme and the S&P 500 Index’s returns unusually dependent on a narrow set of AI-exposed mega-caps, today’s setup echoes those earlier inflection points. Reallocating toward small- and mid-cap equities therefore serves a dual purpose: it targets the catch-up opportunity described above while reducing exposure to a market whose returns are increasingly driven by a handful of names and a single dominant theme.
3. The Macro Backdrop Reinforces the Case
A still resilient U.S. economy, a Fed that eased through late 2025 and has since paused without reversing course, fiscal stimulus that disproportionately benefits domestic producers, and a softening dollar all reinforce the same investment thesis, a combination one strategist described as “a powerful one-two punch of an economy doing better than expected, supported by fiscal and monetary stimulus, combined with broadening earnings growth.”
4. Another Catalyst — Why This AI Cycle Can Sustain Small-Cap Leadership
The PHLX Semiconductor Index rose more than 82% in the first half of 2026, its best first-half performance in years, and the resulting lofty semiconductor valuations have prompted comparisons to 1999–2000. We think the comparison is worth engaging directly rather than waving away—but our conclusion is that this cycle’s structure makes the earnings stream flowing to smaller companies more durable, not more fragile, than the dotcom analog implies. That durability is central to the case for sustained SMID and small-cap outperformance: the AI buildout is not a one-quarter revenue spike for smaller suppliers but a multi-year, contracted demand cycle whose benefits broaden well beyond the mega-cap names capturing today’s headlines. Three structural features distinguish this cycle and underpin that view.
- Funding sources. The dotcom and late-1990s telecom buildouts were substantially funded by external capital—equity issuance and junk debt—chasing revenue-light “story stocks.” Today’s hyperscaler capex is funded largely from internally generated free cash flow at highly profitable companies. That matters for smaller suppliers because their demand is anchored to the reinvestment of durable cash flows rather than to fickle capital-market access. A slowdown would look more like capex normalization at solvent buyers than a debt-driven cascade that abruptly strands supplier order books.
- Buyer quality. Dotcom-era small-cap telecom and fiber suppliers often sold into other speculative, unprofitable companies. Today’s SMID and small-cap infrastructure suppliers are selling into a handful of the most cash-generative companies in the world—typically against multi-year, already-contracted backlogs. That contracted revenue visibility is precisely what allows analysts to underwrite the improving small-cap earnings trajectory with more confidence, and it is what can carry relative outperformance beyond a single momentum-driven year.
- Direction of the bottleneck. The dotcom buildout raced ahead of realized demand. The current constraint—power generation, grid capacity, and cooling—is arguably running behind demand rather than ahead of it. This creates a long runway for the downstream beneficiaries that populate the SMID and small-cap universe (electrical equipment, power infrastructure, cooling, and industrial suppliers), extending the earnings tailwind rather than front-loading it.
We do not think overbuild risk is zero—fiber-glut-style outcomes occurred in the 1990s even where the underlying demand thesis proved directionally correct. But the funding, counterparty, and demand characteristics of this cycle argue for a more durable and broadly distributed earnings stream than 1999–2000 delivered, and should AI capex growth decelerate, a shallower and more orderly unwind. Taken together, these features suggest the recent leadership shift toward smaller names rests on a genuine, multi-year fundamental catalyst rather than a transient rotation—an important condition for the outperformance to be sustained.
Risks to the Outlook
Conviction does not mean certainty. Several risks could mute or interrupt the rotation.
- A Fed reversal. The Fed has paused for four consecutive meetings, and the June 2026 dot plot shows a modest, still sub-50% chance of a hike this year. It was a sustained hiking campaign, not a single move, that ended the 2016 and 2020–21 small cap rallies, so one hike on its own would not necessarily repeat that pattern; a resumed, multi-hike tightening cycle is the scenario we would view as a genuine threat to the rotation. We continue to monitor the Fed’s path alongside the other factors below, given the rotation’s resilience through the pause so far.
- AI capex reacceleration or overbuild. This is the most important company/sector-specific risk to our thesis. A larger or more profitable buildout could reconcentrate leadership in mega caps; conversely, while we believe the funding and demand characteristics of this cycle argue against a 1999-style bust, the risk of a capex slowdown flowing through to SMID and Small cap suppliers is not zero.
- Tariff driven input cost pressure. Tariffs on imported machinery and materials raise costs for many smaller manufacturers, which have more limited pricing power.
- Earnings disappointment in cyclicals. Small caps are more procyclical and leveraged to economic growth; a sharper than expected slowdown would hit them disproportionately.
Investment Implications
For allocators and advisors, the tactical and strategic implications differ.
Strategically, the case for a higher long-term allocation to smaller companies looks more compelling than at any point in the last decade, both as a return opportunity and as a means of reducing concentration risk. We would caution that mean reversion in valuation alone is not a thesis – fundamentals must follow, and the dispersion of outcomes within the small cap universe is wide.
Tactically, we believe a systematic, quantitative approach is particularly well suited to the small cap segment. The median small cap manager has historically outperformed the Russell 2000 across most calendar years, while the median large cap manager has not outperformed the S&P 500 in the same way. Less analyst coverage, wider dispersion in earnings estimates, and lower benchmark concentration give disciplined active managers an analytical advantage that systematic factor screening, liquidity modeling, and risk controls are well positioned to capture.
It is worth adding one nuance – the early rebound off the April 2025 low was led disproportionately by lower quality, speculative names, typical coming out of market bottoms, and a pattern that tends to fade within about twelve months. As that fades, higher quality small caps with healthy margins should reassert leadership, favoring selective, quality aware portfolio construction processes (Chart 8).
Conclusion
After thirteen years of waiting for the leadership baton to be passed, the past four quarters have produced the most convincing signs to date that the relay is underway. The August 2025 Powell pivot lit the fuse, the Q1 2026 down market confirmed the dynamic’s durability, and cumulative outperformance through Q2 2026 now shows up in breadth and earnings forecasts, not just headline returns.
We do not believe leadership shifts in equity markets are smooth, and we expect periods of volatility and short-term reversion; this would not be the first small cap rally to fade, and we have tried to be explicit about the conditions under which it could happen again, including a Fed policy path that has not turned into a headwind but bears watching. Still, the weight of the evidence, a durable valuation gap, index weight catchup, a differentiated AI capex transmission mechanism, and a supporting diversification benefit, suggests that the resurgence of smaller names is not a tactical bounce but the early innings of a multi-year regime change.
This report is neither an offer to sell nor a solicitation to invest in any product offered by Xponance® and should not be considered as investment advice. This report was prepared for clients and prospective clients of Xponance® and is intended to be used solely by such clients and prospective clients for educational and illustrative purposes. The information contained herein is proprietary to Xponance® and may not be duplicated or used for any purpose other than the educational purpose for which it has been provided. Any unauthorized use, duplication or disclosure of this report is strictly prohibited.
This report is based on information believed to be correct but is subject to revision. Although the information provided herein has been obtained from sources which Xponance® believes to be reliable, Xponance® does not guarantee its accuracy, and such information may be incomplete or condensed. Additional information is available from Xponance® upon request. All performance and other projections are historical and do not guarantee future performance. No assurance can be given that any particular investment objective or strategy will be achieved at a given time and actual investment results may vary over any given time.