While mega caps have shined bright over the last several years, another player will inevitably take over the spotlight. With small caps seeing rallying hard over the last several months, it is their turn be the star of domestic equities in 2026?
2025 has been another solid year for financial markets, with large caps once again leading the way to the upside. However, close behind them have been small caps, with the 14.4% YTD return for the Russell 2000 (RUT) trailing closely behind the 16.1% gain for the S&P 500 (SPX). While mega caps have shined bright over the last several years, another player will inevitably take over the spotlight. With small caps seeing rallying hard over the last several months, it is their turn be the star of domestic equities in 2026?
This year's gains have resulted in significant technical improvement for the iShares Russell 2000 ETF (IWM) chart as it trades back at all-time highs. IWM regained near-term relative strength versus the market (SPXEWI) in September, allowing it to possess a strong fund score of 4.43. While small caps pulled back in October, the fund has since reversed back into a column of Xs while breaking through a double top at $255 for its second consecutive buy signal. Additionally, this improvement in price has also seen follow through from participation indicators, with the bullish percent for the S&P SmallCap 600 (^BPSPSML) reversing back to healthy levels near 60% after dropping steadily in September and October.
Small caps sit closely behind large caps not only by performance but also in terms of relative strength. IWM now holds a fund score within 0.75 points of the iShares S&P 500 ETF (IVV), marking the smallest gap in strength between the two funds since early 2023. One knock against small caps has been the inconsistency of the group, often seeing sharp and unstained rallies in either direction, as seen in the movement of IWM’s fund score. For investors to have further confidence in the group, small caps need to hold onto consistent strength next year, as rebounds have been followed by slowdowns in recent years.
One narrative behind the recent improvement of small caps is that a decline in rates served as a tailwind for smaller rate sensitive companies that have a greater reliance on borrowing and a higher exposure to floating rate debt. The ten-year treasury yield (TNX) is down 40 basis points from its peak in May, during which the Russell 2000 gained 24.7%. The ten-year yield was previously on four consecutive sell signals and trading in a negative trend, but action last week saw the index break a double top at $42 to flip its trend back to positive, creating potential interest rate pessimism for the small cap trade.
While higher rates would undoubtedly hurt small caps, large caps (green line) have displayed a stronger negative correlation to rates than small caps (blue line) over most of the last several years, as seen in the graph below. Said plainly, a change in interest rates has not coincided with more movement for small caps compared to large caps, suggesting a rise in rates might not doom small caps to underperform large cap stocks. Additionally, there are other reasons to be cautiously optimistic about smaller stocks.
In the second half of this year, small caps have thoroughly outperformed large caps, with the Russell 2000 gaining 17.3% compared to a respectable 10% for the S&P 500. That puts RUT on track to beat SPX for the fourth consecutive back half of the year. While the index’s second half momentum hasn’t translated into continued relative strength over full years recently, a strong latter half from RUT has historically been a positive sign for the small cap index. Specifically, the Russell has averaged an 8.1% next-year gain when it underperformed the S&P 500 over the last six months of the previous year. Meanwhile, the index has averaged a much heartier 12.2% return next year when it outperformed SPX over the previous six months, serving as a positive sign for small caps as we look ahead to next year.
Large caps continue to be the dominant force of the market, remaining the size group with the most relative strength. However, that isn’t to say other groups aren’t worth keeping an eye on, especially as small caps enter next year with some steam behind them. Should the Russell 2000 hold up rather than breakdown, small caps would deserve a place in most investors’ portfolios in 2026.
