Small-cap stocks are on track to finish 2025 with their fifth straight year of underperforming large caps. That's a brutal stretch by any measure. But Bank of America thinks the tide is finally turning, and 2026 could be the year small caps stage a comeback.
In a note released Tuesday, Bank of America strategist Jill Carey Hall made a bold call on the Russell 2000—tracked by the iShares Russell 2000 ETF (IWM)—saying she expects small caps to "outperform mid and large caps" as economic conditions shift in their favor.
The bank outlined five specific catalysts that could spark a multi-year rally for smaller companies. Here's what they're seeing.
Earnings Growth Is Accelerating
Profit momentum matters, and it's moving in the right direction for small caps. Analysts are forecasting S&P SmallCap 600 earnings to jump 19% in 2026, comfortably ahead of the 13% expected for the S&P 500 and 15% for the S&P MidCap 400.
When small-cap earnings growth both exceeds and accelerates relative to large caps, history shows smaller companies tend to outperform by an average of 9 percentage points. That's a meaningful edge.
Capital Spending Boom Benefits Smaller Companies
Bank of America sees a powerful capital expenditure cycle taking shape, driven by infrastructure upgrades, hyperscale data center construction, reshoring efforts, and automation investments.
"Our work suggests that small-cap sales growth is more highly correlated to capex than large caps," Hall noted.
When corporate America opens the spending taps, small-cap revenue growth historically follows. That relationship creates a significant tailwind heading into 2026.
Rate Cuts Provide Much-Needed Relief
Smaller companies are more sensitive to interest rates than their larger peers. They typically carry more floating-rate debt and have shorter debt maturities, which means higher rates hit them harder.
With the consensus calling for three Fed rate cuts in 2026, relief is coming. Hall estimates that higher rates have dinged Russell 2000 non-financial operating earnings by as much as 32% over five years. Each 25 basis point cut could reduce that impact by roughly 2 percentage points.
History backs up the thesis. In about 60% of recession-linked easing cycles, small caps have outperformed large caps in the year following the first Fed rate cut.
Deregulation and Tariff Relief Could Expand Margins
Regulatory compliance costs fall disproportionately on smaller firms. According to a 2023 National Association of Manufacturers study cited by Hall, companies with fewer than 50 employees face annual compliance costs of $14,700 per worker—20% higher than firms with more than 100 employees.
While fewer than 15% of Russell 2000 companies fit that size profile, the data suggests meaningful margin improvement could come from potential deregulation.
Tariff uncertainty crushed small caps early in 2025, but Hall believes relief from exemptions or legal challenges could provide a significant boost to margins next year.
Positioning and Valuations Look Attractive
Small caps have been completely ignored by institutional investors. Multi-cap fund managers are currently 60% underweight the segment—the lowest allocation since the Global Financial Crisis.
But the flows are starting to reverse. Bank of America's client data shows investors are finally buying small-cap individual stocks this year, and hedge fund inflows have picked up recently.
Retail investors are also playing a bigger role. Retail participation in small caps has surged since 2023, averaging 35% to 40% of trading volume. Historically, small caps have outperformed during periods of elevated retail activity.
Then there's valuation. The Russell 2000's forward price-to-earnings ratio of 16 sits just slightly above its long-term average. But relative to large caps, small caps look cheap. The forward P/E ratio of 0.72 is well below the historical norm of 0.99.
Bank of America's regression models project that over the next decade, small caps could deliver annualized returns of 9%, far exceeding the 1% expected from large caps.
"Our work suggests that valuation tends to be a poor short-term timing indicator, but it matters much more for long-term (10-year) returns," Bank of America wrote.
After five years in the wilderness, small caps might finally be setting up for their moment.