Small-Cap Stocks Have Been Waiting Years for Their Moment. Is It Finally Here?
Key Points
The Vanguard Small-Cap ETF is beating the Vanguard S&P 500 ETF by 6% year to date.
It's done this based on accelerated earnings forecasts, better valuations, and stagnant performance from the "Magnificent Seven" stocks.
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Small-cap investors have been waiting a long time for this moment. For most of the past 15 years, small stocks have lagged the S&P 500. But in 2026, things are beginning to reverse, as shown by two exchange-traded funds (ETFs). The Vanguard Small-Cap ETF (NYSEMKT: VB) is outperforming the Vanguard S&P 500 ETF by 6% year to date.
We've seen these kinds of rallies before in small caps only to see them fizzle out within six months to a year. The recovery from the COVID bear market was a prime example. From the March low of 2020 through the end of the year, the Vanguard Small-Cap ETF beat the S&P 500, gained nearly 100%, and outperformed the S&P 500 by 29 percentage points.
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The big question now is whether 2026's rally is just another rally-and-fade or is sustainable. Current evidence suggests it might be the latter.
Source: Getty Images.
Small caps still have one big advantage
The artificial intelligence (AI) boom has evolved from stock prices rising on pure potential to the market wanting to see tangible results. Some companies have delivered. Some have missed the mark. Those mixed results have led to investors paying more attention to valuations and becoming less willing to pay high prices for growth stocks.
That's a big part of why we've seen a rotation from growth into value this year. And it's been a big reason why small caps are back in demand.
The Vanguard Small-Cap ETF currently trades at a forward price-to-earnings ratio (P/E) of 17, a sizable discount to the 20 multiple that the Vanguard S&P 500 ETF is trading at.
Earnings could finally provide the catalyst
The bigger upside catalyst for small caps is likely to come from fundamentals.
For the past few years, small caps have lagged because of stagnant (and sometimes negative) earnings performance. Rising interest rates and tariffs hurt the financial health of these companies, while investors' focus on megacaps during the AI trade negatively impacted stock prices. But that trend is turning around.
Small-cap earnings growth is expected to accelerate to 18% in 2026 and another 18% in 2027. If the latter holds true, it could be the first time in several years that small-cap earnings growth exceeds that of large caps.
If you can get better earnings growth from a category whose P/E ratio is 15% cheaper, that's a compelling investment opportunity. And it's one that has the fundamental strength to last far beyond one year.
There's still one big obstacle
Interest rates are the one factor that could be a headwind to small-cap outperformance.
Since these companies tend to be more reliant on debt to fund operations and growth initiatives, they're disproportionately impacted by higher interest rates. It was a big driver of relative performance during the Federal Reserve's aggressive rate-hiking cycle in 2021, and it could factor in again over the next few quarters.
Rate cuts, which could have eased some of their cash flow pressures, look like they're off the table for the foreseeable future. If interest rates continue to drift higher, as they have for the past six months, it will put added financial pressure on smaller companies.
The anticipated earnings acceleration should help offset some of that, but it's a relative disadvantage that larger companies won't be nearly as impacted by.
Is it too late to buy small caps?
I don't believe so. Not only is a prolonged stretch of small-cap outperformance overdue, but it's also now getting the fundamental support to make it happen. This year's leadership is just a short-term example of what the group can do when financial health is improving.
I would not make any radical portfolio allocation changes, but migrating some percentage of equities from large-caps to small-caps makes sense.
The Vanguard Small-Cap ETF is one of the cheapest and broadest ways to accomplish that. It owns roughly 1,300 stocks and charges just 0.03% annually. It doesn't rely on picking winners. It just buys the theme, which is the better way to tilt your portfolio.
The small-cap comeback that investors have been waiting on may finally be here.
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David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
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