Historical lens – Catch up potential
Despite recent gains, small caps, as proxied by the S&P Small Cap 600, continue to trail large caps by 12% over the past year
On a 3-year rolling basis, the underperformance nears the most extreme divergence since 2000. This historical gap presents a potential catch-up opportunity, especially if macro conditions stabilize.
Fundamentals – Improving trends and valuation support
Relative valuations for small caps remain attractive—a persistent theme. What’s changed is the quality of price action as recent gains are now supported by rising earnings trends, marking a notable shift from earlier in the year.
Additionally, provisions in the One Big Beautiful Bill around interest rate deductibility favor more leveraged and capital-intensive firms, which tend to be concentrated in the small-cap space.
The anticipated commencement of Federal Reserve (Fed) rate cuts should also provide some modest relief, given small caps’ higher exposure to floating-rate debt. A slight pickup in economic activity and an uptick in M&A further support the case for a neutral stance.
Market signals – Technical trends turning positive
Small caps have been in a steady price uptrend over recent months. Notably, the 50-day moving average recently crossed above the 200-day moving average, a positive signal. Additionally, the relative price of small caps compared to large caps has risen to a multi-month high, reinforcing the shift in sentiment.
Why not move to more attractive?
While short-term momentum has improved, we do not yet see a sustained reversal in relative earnings or price trends versus large caps from a longer-term perspective.
Secular leadership remains with tech, where earnings strength and margin resilience continue to dominate. The macro backdrop is still clouded by uncertainty—particularly around the pace of Fed cuts and cost pass-through dynamics. Small caps, with fewer operational levers, remain more vulnerable in this environment.
Moreover, while we expect modest economic improvement into 2026, it does not resemble the robust growth typically required to drive sustainable small-cap outperformance.
Bottom line:
We are upgrading small caps to neutral as the weight of the evidence has shifted. Valuations remain attractive, earnings trends are improving, and technical signals are turning more constructive. These recent developments warrant a more balanced view.
As always, we will continue to follow the weight of the evidence and keep an open mind.
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