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Small-cap stocks have long held the promise of outsized returns, driven by nimble business models and domestic exposure. Yet, in recent months, they’ve found themselves under relentless pressure, buffeted by broad economic forces that favor larger, more diversified firms. Investors face the dual challenge of understanding the depth of this underperformance and plotting a path toward opportunity.
The key US small-cap benchmark, as measured by the Morningstar US Small Cap Extended Index, fell 23% from its postelection high between November 2024 and early April 2025—a drop that technically qualifies as a bear market. This performance gap is not a sudden aberration. In fact, no meaningful outperformance of small caps over the broad US equity market has emerged since 2016.
Across multiple years, large caps have steadily widened their lead, a trend that now mirrors patterns last seen during the tech bubble of the early 2000s. Such long stretches of divergence can feel discouraging, but they also lay the groundwork for potential mean reversion when conditions shift.
Several overlapping macro events have compressed small-cap returns over the past half-decade. Pandemic-related disruptions, massive fiscal stimulus, lingering supply chain shocks, surging inflation, aggressive monetary tightening, and geopolitical instability have each played a role.
Unlike their larger counterparts, small companies often lack significant pricing power and hold tighter profit margins. They are more exposed to rising input costs and face higher borrowing costs at a time when central banks remain cautious about inflation. In the UK and other markets, additional strains—tariffs, trade policy uncertainty, and currency fluctuations—have compounded these pressures.
Despite the ongoing challenges, small caps are trading at multi-year lows in relative valuations. Forward price-to-earnings multiples sit well below those of large caps, creating a historic discount. History suggests that extended periods of underperformance can set the stage for powerful rebounds when the macro backdrop shifts.
On average, cycles of large-cap outperformance have lasted about 11 years; the current stretch has now reached 14 years. As cycles mature, investor attention and capital flows often rotate toward undervalued areas, particularly when economic indicators hint at renewed growth.
Small- and mid-cap companies offer broader sector diversification compared to the heavy tech weighting of major large-cap indices. While large caps have leaned into technology and communication services—now over 40% of certain benchmarks—small caps maintain meaningful representation in industrials, consumer discretionary, and healthcare.
This domestic tilt can be an advantage during recoveries driven by local demand. When consumer spending picks up or infrastructure projects accelerate, smaller firms often feel the impact more directly and sooner than global giants reliant on international markets.
High interest rates and inflation have disproportionately hurt small caps due to their higher debt servicing needs and limited ability to pass costs onto end customers. Periods of rate cuts, conversely, have historically aligned with small-cap rallies, as lower financing costs and lighter financial burdens free up capital for growth.
Regulatory and tax policy swings also play a pivotal role. Deregulation and targeted tax relief can provide tailwinds for smaller businesses, while rising rates remain a persistent headwind. Watching central bank communications and fiscal policy developments is essential for anticipating market shifts.
Small caps frequently serve as acquisition targets for larger firms seeking niche capabilities or growth avenues. An uptick in M&A activity not only supports share prices but signals confidence in underlying corporate health.
Meanwhile, the small-cap universe is notoriously inefficient. With fewer sell-side analysts covering these stocks, skilled active managers can identify mispriced opportunities and generate alpha. As passive flows concentrate in mega-cap giants, active strategies focused on smaller names may find fertile ground.
Looking ahead, many portfolio managers are optimistic about small caps in 2025. Anticipated drivers include a broadening of the economic expansion, potential rate cuts, deglobalization trends, and the reshoring of supply chains—factors that could favor domestically rooted companies.
While the path back to outperformance may not be linear, the combination of depressed valuations, potential policy relief, and a shifting economic cycle presents a compelling case for a strategic allocation to small caps. By staying informed and remaining patient, investors can position themselves to benefit when the tide turns.
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