Small-Cap Stocks: A Shift in Performance
Underperformance in Recent Years
Small-cap stocks have struggled compared to larger companies in the past several years. The S&P 500 has reached record highs, driven by a select few large positions—often referred to as the “Magnificent Seven.” In contrast, the Russell 2000 small-cap index has lagged significantly, showing a total return of only 203% over the last decade, which is 120 percentage points behind the S&P 500’s 323%.
2026: A Potential Turning Point
As of mid-2026, small-cap stocks are experiencing a remarkable resurgence, up over 20% in the first half of the year—marking their best start since 1991. Historically, such trends are rare, with the last comparable performance occurring in 2003.
Factors Behind the Outperformance
1. Valuation Gap Closure
At the beginning of 2025, small-cap stocks were trading at their lowest relative valuations since the late 1990s. By 2026, the average stock in the Russell 2000 was trading at about 18 times forward earnings, significantly lower than the S&P 500’s more than 26 times. This indicates that small-caps are currently undervalued and present a buying opportunity.
2. AI Tailwinds
Smaller firms are beginning to benefit from the artificial intelligence boom. There’s growing demand for products and services from smaller suppliers and chipmakers involved in AI infrastructure. Consequently, earnings growth estimates for Russell 2000 constituents have jumped from 23% to 38% since early 2026.
Investing in Small-Cap Stocks
Despite the current outperformance, now may not be the time to disregard small-caps. Historically, similar valuation gaps have led to prolonged periods of outperformance for small-cap stocks.
For those looking to diversify their portfolio with small-cap stocks, consider investing in a small-cap ETF, such as:
- Vanguard Russell 2000 ETF (VTWO): A cost-effective way to gain exposure to small-cap stocks.
- Vanguard Small-Cap Value ETF (VBR): Focuses on undervalued small-cap stocks.
Both ETFs are considered strong long-term investments.
