Small-Cap Equities: A Cyclical Revival on the Horizon?

The cyclical nature of small-cap equities has long been a cornerstone of equity market dynamics. Historically, small-cap stocks have outperformed large-cap counterparts during economic recoveries and risk-on environments, only to underperform in late-cycle or risk-off phases. After a prolonged 12-year underperformance cycle-the longest in history-small-cap equities are now approaching a potential inflection point. With macroeconomic conditions shifting and valuations reaching historically attractive levels, investors may be poised to capitalize on an impending cyclical revival, as a CFA Institute blog reports.

A Decade of Underperformance and Structural Headwinds

Small-cap stocks, as measured by the Russell 2000 Index, have trailed the S&P 500 by a significant margin over the past 12 years. This underperformance has been exacerbated by structural factors, including elevated interest rates, regulatory burdens, and the influx of lower-quality companies into small-cap indices, according to an Investing.com analysis. However, historical cycles suggest that such extended underperformance is often followed by a reversal. The average small-cap leadership cycle lasts approximately nine years, meaning the current phase may soon give way to a period of relative strength, according to Marquette Associates.

Recent data underscores this potential shift. For instance, the Russell 2000 surged 8.5% in Q2 2025, while the Russell Microcap Index gained 15.5% in the same period, signaling resilience amid earlier volatility, according to a Royce recap. These gains align with broader trends: small-cap value stocks, which had traded at multiyear lows relative to the S&P 500, are now showing signs of rerating, according to a Wellington outlook.

Catalysts for a Cyclical Revival

Several macroeconomic and policy-driven factors are converging to support a small-cap rebound. The Federal Reserve's rate-cutting cycle, coupled with easing inflation concerns, has improved liquidity conditions for smaller firms. Narrowing high-yield spreads and rangebound intermediate-term interest rates further suggest a more favorable funding environment, according to a Bloomberg outlook. Additionally, the One Big Beautiful Bill Act (OBBBA), enacted in late 2024, allows businesses to fully deduct domestic R&D expenses, potentially boosting small-cap profitability and cash flow, as an MSCI blog post notes.

Valuation metrics also highlight compelling opportunities. Small-cap stocks currently trade at a 30% discount to large-cap peers on a forward price-to-earnings (P/E) basis-the widest gap since the dot-com bubble, a J.P. Morgan note shows. Their average price-to-book (P/B) ratio of 1.66 is significantly lower than the 2.59 for the weakest segment of large-cap stocks, while return on assets (ROA) for small caps stands at 0.9%, compared to -2.3% for the bottom quintile of large-cap equities, according to a Wellington analysis. These discrepancies suggest small caps are undervalued relative to their fundamentals.

Challenges and Risks

Despite these positives, risks remain. Trade tensions and geopolitical uncertainties continue to weigh on small-cap performance, particularly for firms with domestic exposure, according to a ResearchGate paper. Moreover, while the U.S. economy has shown resilience, sustained growth is necessary to fully realize the potential of small-cap stocks. Academic research indicates that small caps historically outperform large caps by an average of 285 basis points annually during recovery phases but lag in late-cycle environments, an MSCI quick-take finds. Thus, investors must remain cautious until macroeconomic signals confirm a durable upturn.

A Strategic Case for Small-Cap Exposure

For investors seeking long-term growth, small-cap equities present a compelling case. Historical data shows a 90% probability of outperformance over 15-year horizons, and the current valuation gap suggests mean reversion is likely, as noted earlier by the CFA Institute blog. While volatility and economic sensitivity are inherent risks, the structural forces-such as rising interest rates and a normalizing yield curve-further tilt the odds in favor of small-cap leadership, according to the Wellington analysis.

In conclusion, the confluence of favorable valuations, improving macroeconomic conditions, and historical cyclical patterns positions small-cap equities as a strategic asset class for the coming quarters. As the market navigates the transition from risk-off to risk-on sentiment, small-cap stocks may emerge as a key driver of portfolio returns.