The small-cap stocks have been flying under the radar of most retail investors amid the magnificent rise of the Magnificent Seven tech giants. More recently, the Mag Seven names have begun to stall, and as the mega-cap tech titans drag their feet in the first few weeks of the year, perhaps it’s no mystery as to why we’ve heard more of the S&P 493 (the S&P 500 minus the Mag Seven). As market strength broadens out, though, I think it’s worth broadening one’s horizons even further to encompass the U.S. stocks outside of the S&P 500.
Undoubtedly, the small- and mid-cap names certainly stand to benefit from further interest rate reductions. With talks of who will be the new Federal Reserve chair and how much more dovish they could be compared to Jerome Powell, perhaps we could get more rate cuts than expected this year. Either way, I think the rate outlook bodes quite well for the small caps, as their debt burdens become lighter while larger firms obtain greater purchasing power, perhaps enough to increase the rate of acquisitions.
While the case for rotating into the small caps seems the strongest it’s been in a number of years, questions linger as to whether such a move is worth doing, especially as the Mag Seven look to regain their footing. Bigger firms have proven better for such a long time now, after all.
Though I think the small caps could do well, perhaps due to the relative undervaluation, I’m just not sure if they can break their streak of trailing the S&P 500 gains. Indeed, the trend suggests that something like the SPDR S&P 500 ETF (NYSEARCA:SPY) is still worth sticking with.
Can you remember the last time that small-cap stocks topped the S&P 500 over a lengthy timespan?
On the one hand, you could say that the small-cap stocks have a stage set for outperformance, especially as the S&P’s higher valuations become more of a drag on returns. At the same time, it’s tough to call when the shift will happen or if it’s even deserved.
After all, economies of scale in the AI age might warrant a higher multiple. And given so much of the S&P 500’s premium is tied to large-cap tech stars, many of which are going big on AI, I wouldn’t be so quick to conclude that the small caps are overdue for a couple of years of big gains, even if lower rates, more M&A, and cheaper valuations are more conducive to a better path forward.
Of course, a number of big banks and pundits believe that the small caps are better positioned than the S&P 500 from here. Undoubtedly, the decade-ahead outlook for the S&P 500 isn’t all too grand. And that’s probably thanks to the incredible returns that we’ve witnessed over the past decade.
It could be a closer race in 2026 as the smaller caps look to make up for lost time
In any case, it’s going to be a closer race, especially if investors start turning away from growth stocks and turning towards the lower-multiple names that may have been neglected in recent years. The small-cap scene is a great place to look if hidden gems and deeper relative value are what one seeks. And given the macro picture is improving the case for owning them, I wouldn’t be against buying smaller, lesser-known names for 2026.
Either way, I think 2026 will be a close race between the S&P 500 and a fund like the Vanguard Mid-Cap Index Fund ETF (NYSEARCA:VO). Instead of asking whether small- or mid-cap stocks will beat the S&P, I think the right question is whether both are worth owning for a new year, given all that there is to gain for the two groups.
The mid-caps have a lot on their side for value investors, but as the AI revolution unfolds, I think it’s also a mistake to throw in the towel on the Mag Seven and other stocks atop the S&P 500, which has become more of a tech-weighed index in the past decade. So, why not consider owning both the smaller caps along with the blue chips?
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