Small-cap stocks are on fire to start 2026. Here's what's driving them, and the risks they face
The Russell 2000 just did something it hasn’t done in nearly 30 years. For the first 14 days of the trading year, the small-cap index outperformed the S & P 500 . That’s the longest streak since May 1996. Analysts went into 2026 expecting upside for small-cap stocks, which have lagged large caps since the start of the bull market in 2022. Hopes for stronger U.S. economic data and a more dovish Federal Reserve improved investor sentiment around the stocks, leading some analysts to predict small caps will outperform their larger peers for the first time since 2020. “Obviously I did not think we were going to get 830 basis points of outperformance in 15 trading sessions, it’s incredible,” said Steven DeSanctis, U.S. small- and mid-cap strategist at Jefferies, who in December predicted small caps would beat large in 2026. While the Russell 2000 on Friday broke its outperformances streak, the index is up 7.5% in its best start to a year since 2021. At one point, it was up more than 10% year to date. The S & P 500, meanwhile, is up just 1%. And while small caps have outperformed at times in the last few years, just to see those relative gains dissipate, the Street thinks this time may be different. “This breakout is not just another fluke and should translate into further outperformance from small-cap equities through 2026,” wrote Canaccord Genuity portfolio strategist Martin Roberge in a Wednesday note. Driving this surge could be a ” January effect ,” according to Jeffrey Hirsch, editor of the Stock Trader’s Almanac. Investors, he said, are dipping into small caps to start the year. Tom Lee, managing partner and head of research at Fundstrat Global Advisors, agreed with Hirsch’s assessment. “When the year starts, everyone sort of says, ‘what’s going to work this year? They look at the large caps, and people talk about how the market’s been doing well for so long,” he said. “So in their minds, small caps … are shinier places to allocate.” Investors expect more rate cuts from the Fed in 2026, which are seen as catalysts for these borrowing cost-sensitive companies. The CME Group’s FedWatch tool shows traders are pricing in two rate reductions before year-end. But Morgan Stanley argues they’re not essential to the small-cap play working this year.Strategist Michael Wilson thinks this is “more about earnings.” .RUT .SPX YTD mountain .RUT vs. .SPX year-to-date chart Earnings improvement for small caps began in the third quarter, DeSanctis said. He also expects that to continue, with a forecast for 13.5% earnings growth in 2026 amid a robust macro environment. “If you think the economy is going to grow 2, 2.5, 3%, that’s going to be better for small, better for cyclicals,” he said. “That’s exactly what we’ve seen performing quite well.” Combined with high M & A activity, the outlook even if a more dovish Fed Chair can’t convince the rest of the committee to push rates lower is strong, he said. The risks Some are skeptical the trade will last, despite the different environment. “This has been a trade with gains concentrated in low-quality names that will ultimately disappoint,” wrote Morgan Stanley Wealth Management chief investment officer Lisa Shalett in a Monday note. The group isn’t immune to macro risks, either. An economic slowdown could drag all equities lower. A sell-off of government bonds, part of the ” sell America ” trade that has appeared at times over the last year, that pushes long-term yields higher even if the Fed doesn’t budge, could hurt . And if inflation reappears and the Fed begins tightening borrowing conditions, investors weary of small caps’ reputation as a low-rate play could back out. The latter is critical to Lee’s outlook. He predicted shortly after the 2024 presidential election on CNBC that small caps could outperform by 100% in the next few years. That didn’t start in 2025, and he blamed the Fed’s hawkish turn that year after cutting in 2024 as making it hard for small caps to break out. So long as that doesn’t happen again, the trade will work, he said. “The absence of hikes is important,” Lee said. “They don’t have to cut, but you just don’t want them to hike.” — CNBC’s Nick Wells contributed reporting
