Key takeaways:

  • Across multiple interest rate cycles, leadership has shifted between large- and small-cap stocks with little regard for the direction of policy rates.
  • If earnings continue to strengthen, smaller companies could be well positioned to participate in a broadening market advance.

08/25/2026 – The recent outperformance of small-cap stocks has been impressive because it has occurred amid two crosscurrents many investors consider unfavorable for the asset class: rising U.S. Treasury yields and a more hawkish Federal Reserve. Conventional wisdom suggests these factors should weigh more heavily on smaller companies than on larger ones. Yet despite these headwinds, small caps have quietly moved higher.

Smaller companies are often viewed as more dependent on external financing and more vulnerable to higher borrowing costs, leading many investors to believe small caps should struggle during periods of rising interest rates. Yet history offers little evidence that interest rates alone have consistently determined the relative performance of small- and large-cap stocks.

Across multiple tightening and easing cycles, leadership has shifted between large- and small-cap stocks with little regard for the direction of policy rates. Perhaps that's because investors have confused a symptom with a cause: higher rates often accompany stronger economic growth, improving business activity, and accelerating corporate profits. In other words, the Fed often raises rates because the economy is strengthening, not in spite of it.

Line chart showing small-cap performance versus large caps since 1996, with relative valuations and returns generally moving in tandem over time.

Focusing exclusively on interest rates risks overlooking the factor that has historically mattered most for small-cap returns: earnings growth and economic resilience. Consensus estimates show earnings per share for the Russell 2000® Index growing at nearly twice the rate of the S&P 500® Index this year and next.

This distinction is especially relevant today. Earnings growth has broadened beyond the narrow group of mega-cap companies that drove market leadership over the past several years. Earnings revisions for smaller companies have improved in 2026, participation has expanded across industries, and economic activity, including manufacturing, has remained resilient despite pockets of weakness. The result is a market increasingly willing to reward a broader set of businesses across market capitalizations and investment styles.

While many investors have drawn parallels between today's market and the late stages of the dot-com era, a more instructive comparison may lie within small caps themselves. Leading up to the technology bubble's peak in 2000, small caps, as measured by the S&P SmallCap 600® Index, endured a prolonged period of relative underperformance and traded at a historically wide valuation discount to the S&P 500. (See chart.)

Yet as market leadership broadened, the narrative shifted dramatically. From 2000 through 2007, small caps outperformed the S&P 500 in each year, by an average of roughly 11% annually. Extending the horizon further, small caps outperformed in 10 of the 11 years from 2000 to 2010, by an average of about 8% per year. This episode serves as a reminder that periods of extreme concentration and persistent relative underperformance often sow the seeds of future leadership.

Author(s)

Mark Hackett, CFA, CMT

Mark Hackett, CFA®, CMT®, CFP®

Chief Market Strategist, Nationwide Investment Management Group

Mark Hackett is the Chief Market Strategist for Nationwide’s Investment Management Group, bringing more than 20 years of experience in the asset management industry to the role.

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