The 2026 Bull Run: Navigating the Institutional Rebalancing and Sector Rotation

As 2025 draws to a close, a significant reallocation of capital is reshaping the investment landscape, signaling a pivotal shift in institutional strategy ahead of the anticipated 2026 bull run. The year has seen a marked rotation from overvalued technology stocks to undervalued cyclicals and small-cap equities, driven by macroeconomic uncertainties and evolving regulatory dynamics. This article examines the structural underpinnings of this shift, the earnings momentum in key sectors, and the strategic implications for investors positioning for 2026.

Institutional Selling in Overvalued Tech Stocks

Institutional investors have aggressively offloaded overvalued technology stocks in 2025, with October alone witnessing a net $42.93 billion in outflows from U.S. equities as concerns over stretched valuations intensified according to SP Global market intelligence. This trend accelerated in December, with Asian equities experiencing the largest foreign outflows in nearly six years, concentrated in high-flying tech stocks as reported by Reuters. The sell-off reflects a broader recalibration as institutions seek to lock in profits amid macroeconomic headwinds, including inflationary pressures and the potential for a prolonged rate-hiking cycle.

Passive investment strategies have gained traction as a response. Institutions are increasingly favoring index and ETF vehicles to capture market exposure without the risks of individual tech stocks. This shift underscores a growing preference for diversification and risk mitigation, even as AI-related sectors remain central to long-term growth narratives.

Inflows into Cyclicals and Small-Caps

While the tech sell-off has been pronounced, capital has flowed into undervalued cyclicals and small-cap stocks, albeit with mixed results. Small-cap equities, as represented by the Russell 2000 Index, demonstrated resilience in November, posting a 0.96% gain amid broader market volatility. Morningstar's analysis highlights that small-value stocks trade 26% below fair value, presenting compelling opportunities for investors seeking value.

However, sector-specific flows have been uneven. Financials and materials faced outflows in November, with the former losing $2.7 billion, while health care attracted $4 billion in inflows. This divergence reflects shifting investor sentiment toward defensive sectors during periods of macroeconomic uncertainty. Cyclical sectors like industrials and energy, however, have shown improved participation in returns, signaling cautious optimism about economic resilience.

Earnings Execution and AI Adoption: A New Paradigm

The 2026 bull run is being driven by a $1 trillion reallocation of capital from AI innovators to adopters, as institutional fund managers prioritize earnings execution. This shift is supported by strong fundamentals in sectors like industrials, health care, and communication services, which are expected to outperform in 2026. Small-cap stocks, in particular, are gaining traction due to attractive valuations, margin expansion potential, and the anticipated impact of the "One Big Beautiful Bill Act" (OBBBA) on borrowing costs and fiscal policy as detailed in a Morgan Stanley analysis.

AI-related investment cycles are also fueling growth. Hyperscalers such as Alphabet, Amazon, and Microsoft are projected to increase AI capital expenditures from $400 billion in 2025 to $520 billion in 2026, contributing 1.6% to U.S. GDP. This momentum is expected to extend to AI adopters, including industrials and health care, which are integrating AI to enhance productivity and operational efficiency.

Regulatory Tailwinds and Macroeconomic Risks

The U.S. regulatory landscape for AI has become a critical tailwind. A December 2025 executive order aims to establish a national policy framework, preempting state-level restrictions that could stifle innovation. By creating a uniform regulatory environment, the order seeks to bolster U.S. AI leadership while addressing concerns over ideological constraints on technological development. However, state laws remain in effect, such as California's AI safety and transparency requirements, which could face legal challenges.

Macroeconomic risks, however, linger. The Federal Reserve is projected to cut rates in 2026, but inflation is expected to remain elevated due to structural factors like labor market constraints and housing shortages. These dynamics could limit the Fed's flexibility, prompting investors to hedge against inflation with real assets such as commodities and infrastructure [5]. Additionally, geopolitical tensions and potential AI disappointments pose risks to the 2026 bull case.

Strategic Portfolio Adjustments for 2026

The institutional rebalancing and sector rotation observed in 2025 highlight the need for proactive portfolio adjustments. Investors should overweight cyclicals and small-caps, which offer compelling valuations and earnings momentum, while selectively allocating to AI adopters with strong execution. Defensive sectors like health care and communication services provide resilience amid macroeconomic uncertainty.

Passive strategies, particularly in small-caps and value-oriented ETFs, remain attractive for capturing broad market exposure. However, active management is critical in small-cap equities, where idiosyncratic risks and opportunities are more pronounced. For AI-related investments, a focus on adopters rather than pure-play innovators may offer a more balanced risk-reward profile.

As the 2026 bull run gains momentum, the key to success lies in aligning with the structural shifts in capital flows, regulatory tailwinds, and earnings fundamentals. The coming year promises both opportunities and challenges, demanding a disciplined approach to sector positioning and risk management.