It has been a long time since investors showed any love for small-cap stocks, which have been shunned while the S&P 500 and Nasdaq have soared on tech-driven bull runs.
In fact, small-caps have underperformed large-caps for eight consecutive years, according to Michael Shannon, a portfolio manager at Glenmede Investment Management.
One of the biggest challenges facing many of the small-cap stocks on the Russell 2000 has been higher borrowing costs, which is a particular problem for many small-cap companies since they “are less likely to be profitable and therefore more dependent on credit,” as Charles Schwab’s Liz Ann Sonders, managing director and chief investment strategist, and Kevin Gordon, director and senior investment strategist, noted.
And borrowing has become substantially more expensive over the past few years as the Federal Reserve raised rates to combat rising inflation.
Also, because smaller companies are generally considered to be riskier borrowers than larger companies, they are most often going to pay higher interest rates.
Sonders and Gordon noted in their report from June that an “improved interest rate environment would be a huge boon for many small-cap companies,” but a rate cut at the time seemed far-fetched as Fed Chair Jerome Powell wanted to put a pause on any action until the central bank could see how President Trump’s tariffs might further impact inflation.
However, three months later, small-cap stocks have finally gotten the rate cut that could finally be the “huge boon” they’ve needed.
After the Fed cut interest rates by 25 basis points on Wednesday, the Russell 2000 index jumped 2.5% the next day to finish at 2,476.70, outperforming the three large-cap benchmark indexes.
This surge gave the small-cap index its first record closing high since November 2021 – snapping a streak of 967 consecutive trading days without notching a high, according to Dow Jones Market Data.
Federal Reserve Bank of Minneapolis President Neel Kashkari wrote in an essay on Friday that he expects the Fed to make two more cuts before the end of the year.
Macro tailwinds boosting small caps
The rally for small caps actually began in August, driven by a drop in bond yields and anticipation of the Fed’s impending rate cut.
Morningstar notes that the small-cap rally – just like the rally in the large-cap space – has been largely driven by tech companies, especially semiconductor stocks. But unlike with large-caps, the next main drivers on the Russell 2000 index are industrials and financials.
According to Morningstar, the companies leading the small-cap rally include: Astera Labs (ALAB), Credo Technology (CRDO), Ciena (CIEN), Unity Software (U) and Rocket Lab (RKLB).
Astera has surged 45% over the past month, Credo is up nearly 63%, Ciena has risen 56.2%, Unity Software has posted a 23.1% gain and Rocket Lab has jumped 17%.
Glenmede’s Shannon points out that the recent surge in the IPO market could further bolster the small-cap index.
He notes that after the Federal Reserve began pursuing a zero-interest-rate policy following the financial crisis of 2008-09, many companies began staying private longer because they no longer needed to pursue funding through the capital markets since they could meet their capital needs in the private markets.
But that appears to be changing.
Excluding companies who have gone public through a special purpose acquisition company (SPAC), there were 95 IPOs thus far in 2025 as of August, raising $12.9 billion, according to Shannon. That compares to 73 deals that raised $16 billion in 2024.
“Should this trend continue, it could boost the quality of publicly traded small-cap companies and make the asset class more appealing to investors,” Shannon wrote.
While the market has been favoring small-cap stocks recently, it remains to be seen whether the conditions hold up to maintain the rally.
“Historically, small-cap stocks do best when the economy is reaccelerating from a slowdown or recession, when the Federal Reserve is easing monetary policy, and when long-term interest rates are declining,” Morningstar’s US market strategist David Sekera wrote in his September stock market outlook. “It appears that two of these three conditions are coming to fruition, with the third still an outstanding question.”
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