After over a decade in the shadows, small-cap stocks, once the darlings of the market, might finally be ready to step into the limelight. For nearly fifteen years, these smaller companies have largely underperformed their larger counterparts. While not as historically inexpensive as they were in the early 2000s, there's a compelling argument to be made that the pendulum of performance is preparing to swing back in their favor, especially after a prolonged period where large caps dominated the returns landscape.
Why Small Caps Are Looking More Attractive
Several key indicators suggest that the tide is turning for small-cap stocks. The Russell 2000, a widely recognized index for small-cap performance, recently achieved an all-time high, a significant milestone after a four-year hiatus.
1. Valuations and Historical Precedent
Historically, small and mid-cap companies tend to perform exceptionally well during periods when overall market returns are moderate or low. This phenomenon is often attributed to their role as "low beta" assets over the long term, meaning they exhibit less volatility relative to the market. Furthermore, market history suggests a pattern of mean reversion: weak decades are typically followed by stronger ones. Given the extended underperformance of small caps, this historical trend bodes well for their future prospects.
2. A Bullish Shift in Earnings Revisions
A rare and incredibly bullish signal has emerged from earnings revisions data. For the first time in years, more than half of small-cap companies are experiencing upward revisions to their earnings forecasts. This metric has consistently stayed below the 50% threshold since the late 1990s. Sustained periods where this measure remains above 50% have historically correlated with robust forward performance for small caps, signaling improved fundamental health.
3. Alleviating Interest Burdens
One of the most significant challenges for small caps has been their greater reliance on short-term debt, making them highly sensitive to interest rate fluctuations. However, this headwind is beginning to dissipate. The interest expense as a share of total debt for small caps has fallen to 6.9%, marking its lowest point in over a year. With market expectations pricing in additional Federal Reserve rate cuts by the end of 2026, the financing costs for small-cap companies are projected to continue easing. This reduction in the cost of capital is a critical game-changer for businesses where financing expenses can heavily influence profitability.
4. Policy Tailwinds: The OBBB Tax Wave
An additional fiscal boost is on the horizon in the form of the "One Big Beautiful Bill" (OBBB) tax refund, estimated to be around $150 billion, which is expected to reach U.S. households in 2026. This influx of capital could be a significant windfall for small-cap businesses for a couple of key reasons. Firstly, small caps generally have high exposure to consumer spending; unlike global mega-caps, they rely heavily on domestic demand. More disposable income in consumers' pockets should directly benefit sectors like homebuilders, retailers, restaurants, and other discretionary areas. Secondly, the OBBB bill includes tax incentives and accelerated write-offs designed to reduce interest expenses, which is particularly beneficial for smaller firms that don't possess the robust balance sheets of corporate giants like Apple or Microsoft. Essentially, the OBBB represents a direct shot of adrenaline into the small-cap economy.
5. Growth Outlook Turns a Corner
After years of struggling to keep pace, the 2026 growth outlook for small caps has undergone a decisive shift for the better. For the first time in over a decade, small-cap companies are demonstrating a sustained path of earnings growth that is projected to outpace their large-cap counterparts.
Sector Bright Spots for Small-Cap Investors
Certain sectors within the small-cap universe are particularly well-positioned to benefit from these evolving market conditions:
- Homebuilders and Banks: Both are highly sensitive to declining interest rates and robust domestic demand.
- Consumer Discretionary: This sector is typically the first beneficiary of increased consumer spending, such as that driven by tax refunds.
- R&D-intensive Small and Mid-Cap (SMID) firms: Companies benefiting from supportive policies like 100% R&D expensing.
These are the areas where the convergence of fiscal tailwinds and easing financial conditions will likely have the most direct and positive impact.
Factors Driving Continued Upside Potential
The potential for sustained upside in small caps is underpinned by several factors:
- Strong Market Breadth: The current rally isn't confined to just a few mega-performers; a broad range of stocks are participating, indicating a healthier underlying market.
- Short Squeeze Fuel: Hedge funds have historically maintained significant short positions against small caps. If prices continue to climb, these short sellers may be forced to cover their positions, thereby pushing stock prices even higher.
- Limited Inflows: So far, investors have not aggressively poured money into small-cap ETFs. This suggests ample room for new buying activity to further fuel the rally without immediate overheating.
- Improving Fundamentals: The projected strong rebound in earnings growth for small caps in 2026, coupled with their decreasing interest costs as a proportion of debt, paints a picture of improving fundamental strength.
Key Takeaways for Investors
- Near-Term Boost: Small caps appear poised for significant cyclical upside heading into 2026, driven by upward earnings revisions, declining interest expenses, and the economic stimulus from the OBBB tax wave.
- Strategic View: While the long-term advantages of scale and AI dominance still favor large caps, especially in business-funded R&D concentration, the next decade could see small caps benefit from cheap valuations, mean reversion, and government-funded R&D support.
- Portfolio Tilt: Tactically, consider positioning portfolios to capture the anticipated small-cap upside as stimulus measures and falling interest rates take effect. Strategically, keeping a close watch on governmental industrial policy and R&D subsidies is crucial, as increased support in these areas could ignite not just a comeback, but a true renaissance for small-cap companies.
Fed Cutting Cycle and Bank Performance
It's a rather uncommon occurrence for the Federal Reserve to initiate rate cuts when bank stocks are performing exceptionally well, often sitting at record highs. This scenario has only unfolded three times in history: in 1992, 1995, and 1996. Typically, the banking sector experiences a significant downturn of 20% or more before the Fed intervenes with easier monetary policy. Interestingly, in those rare instances, bank stocks not only held their ground but often continued to lead the broader market afterward. Today's conditions bear a striking resemblance: credit markets remain stable, high-yield spreads are tight, and the market rally is broad-based across various sectors.
For retail investors, the key implication is that a rate cut in this environment should not be viewed as a signal of economic distress. Instead, it appears to be a proactive effort by the Fed to extend the economic cycle. This could mean that financial stocks and other cyclical segments of the market still have considerable room to grow, even amidst shifts in monetary policy. While diversification remains a crucial strategy, historical patterns suggest that strength in the banking sector can serve as a positive harbinger for equities more generally.
Emerging-Market Stocks Outpace the S&P 500
The iShares MSCI Emerging Markets ETF has shown impressive performance recently, gaining 1.6% last week and marking its third consecutive week of increases. Since its low in April, the ETF has rebounded by 39%, outperforming both the STOXX Europe 600 (21%) and the S&P 500 (37%) over the same period. While European and US indices have frequently hit record highs this year, the EM ETF still has ground to cover to reach its all-time high, with a gap of 9%. The prevailing uptrend suggests that a test of this all-time high is plausible in the coming months.
This rally in Emerging Market (EM) equities largely reflects anticipations of improved economic conditions globally. Markets are inherently forward-looking and typically react ahead of real economic shifts. A critical factor for EM economies remains their dependence on the U.S. dollar and American interest rates. Many companies in these markets borrow in dollars; consequently, falling U.S. rates make funding cheaper, and a weakening dollar reduces the local currency cost of that dollar-denominated debt. After a prolonged pause, the Fed recommenced cutting rates last week and indicated two more such moves by year-end. The macroeconomic tailwind from these policies will likely filter into the real economies of EM countries gradually.
Moreover, EM countries often boast higher growth rates. In 2024, economies such as India (6.5%), Malaysia (5.1%), China (5.0%), and Indonesia (5.0%) demonstrated growth of five percent or more. These figures significantly outpace those of developed nations like the U.S. and particularly Europe. This robust growth potential encourages many investors to look beyond their domestic markets, utilizing the global equity universe to achieve broader portfolio diversification.
Rheinmetall Expands into Shipbuilding
Rheinmetall is poised to acquire the naval division of the Bremen-based Lürssen Group, with the transaction expected to close in early 2026. This acquisition is estimated to be valued at approximately €2 billion. The division includes four shipyards located in northern Germany, along with several international operational sites, employing around 2,100 individuals. In 2024, this unit generated roughly €1 billion in revenue. Rheinmetall's management is targeting an EBITDA of approximately €300 million by 2027, with the margin projected to increase from its current 10% to 15% by 2030. Concurrently, Rheinmetall aims to achieve at least €5 billion in revenue from its newly formed naval segment. The strategic focus will be on naval munitions, particularly rocket motors and final assembly, areas currently experiencing high global demand and often characterized by lead times stretching several years.
Rheinmetall's stock currently trades at a forward P/E ratio of 52, a valuation that underscores the exceptionally high growth expectations investors have for the company. This figure stands in stark contrast to the average P/E of 28 across six major global defense companies (RTX, Safran, Honeywell, Lockheed Martin, Rheinmetall, and BAE Systems). However, Rheinmetall's last twelve months (LTM) EBIT margin of 13.9% is notably above the peer average of 13.2%.
The stock briefly reached a new record high of €1,979 last week, though the breakout above its June high did not sustain itself. The Relative Strength Index (RSI) currently at 72, also suggests that the market is slightly overbought in the short term. While these are minor warning signs, the long-term uptrend remains intact as long as the €1,320 low holds. Should the breakout above the June high be successful and sustained, potential price targets based on Fibonacci extensions could be €2,110, €2,279, €2,367, and €2,494.
