3 Reasons Small-Cap Stocks Could Outperform in 2026 -- and 1 Fund to Buy Now

Small-cap stocks, or publicly traded companies valued anywhere from $300 million to $2 billion, lagged the broader markets in 2025. The Russell 2000, which tracks the performance of 2,000 small-cap stocks, returned 12% over the last year compared to the S&P 500's 17% rise. While not a huge gap, the underperformance is part of an ongoing 15-year streak of small caps trailing large-cap companies.

Yet, this 15-year run is an historical anomaly. It's been well documented that small caps have outperformed large caps over the last century, beating them by an average of 2.85% a year since 1927. And for every 10-year investing window, small caps beat large caps two-thirds of the time.

For context, the S&P 500's average annual gain of 10.37% since 1927 would have turned $100 into a whopping $1.75 million with dividends reinvested. But when you tack on the extra 2.85% in average annual outperformance that small caps enjoyed, the figure swells to $21.8 million.

What's most interesting to me is that small-cap and large-cap market leadership tends to run in cycles, with large caps leading the way from 1946 to 1957, from 1969 to 1974, from 1999 to 2010, and most recently from 2011 to 2026, according to data compiled by Wellington Management. This means that this streak of large-cap dominance hasn't just lasted longer than usual; it's the longest era of large-cap market leadership on record.

Of course, large-caps' big run can't last forever. And increasingly, a number of big banks and institutional heavyweights are forecasting the end of an era in 2026, as large caps finally hand over the baton to small caps, and the historical norm reasserts itself.

In their annual investment outlooks for 2026, Vanguard forecast significantly more potential upside for small caps, while Invesco called small caps attractively valued. Meanwhile, Chris Hyzy, chief investment officer of Merrill and Bank of America Private Bank, pointed to small caps as one of several potential tools to "power your investments into a new era of growth."

Three reasons small caps could shine in 2026 and beyond

Small caps and large caps rarely trade their market dominance every year or so; the runs of outperformance last over six years on average. So the question of whether small caps could be about to wrest leadership from their bigger siblings is likely one of multi-year importance. And there are three reasons to believe that small caps will outperform this year.

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First, there's valuation. The S&P 500 carries an average price-to-earnings (P/E) ratio of 31, while the Russell 2000 carries an average P/E of just 18. Lower P/E ratios indicate better bargains, tilting the odds more in investors' favor. As the great Warren Buffett famously asserted, excessive valuations are like gravity to stocks -- "The higher the rate, the greater the downward pull."

Second, there's the likelihood of interest rates falling further in 2026. With the Federal Reserve's next decision on interest rate policy due in just a few weeks, traders are forecasting no imminent change in rates, but they do pin the likelihood of interest rate cuts by late April at 61%.

And with Fed Chair Jerome Powell speculating that recent jobs reports showing unemployment ticking up to a multi-year high might still be too rosy, the Fed could be inclined to surprise with an imminent rate cut, especially if December's jobs numbers underwhelm. Small caps have more upside from falling rates because they are more heavily reliant on floating-rate debt, which can be refinanced more easily at lower borrowing costs.

Finally, and on a related note, small-cap companies tend to outperform during recessions, with the most recent examples being during the early months of the pandemic and from 2007 to 2013. Part of the reason for this is that the Fed lowers interest rates to fight recessions, but it's also the case that small-cap companies are more nimble and able to pivot to new economic conditions.

A simple way to play a small-cap comeback

The iShares Russell 2000 ETF (NYSE: IWM) is an exchange-traded fund that seeks to track the performance of small-cap U.S. stocks. As of December, its holdings totaled 1,962 small-cap stocks, meaning anyone owning shares gained exposure to almost 2,000 small-cap companies.

Since its May 2000 inception, the fund has achieved average annual gains of 8.05%, which is impressive considering that this 15-year era of large-cap outperformance amounts to more than half of the fund's 26-year history.

The fund also charges a management fee of 0.19%, which is considerably less than the industry average that generally falls into the range of 0.44% to 0.63%. For investors seeking a simple, low-cost, and catch-all way to play a resurgence for small caps, the iShares Russell 2000 ETF is worth considering.

William Dahl has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.