The Case for Small-Cap Rotation in a Broadening US Equity Rally

The US equity market is undergoing a profound structural shift. For years, the dominance of large-cap technology stocks—particularly the so-called “Magnificent Seven”—defined market performance. However, in 2025, a striking reversal has emerged. Small-cap stocks, long sidelined by high valuations and macroeconomic uncertainty, have staged a compelling comeback. This rotation is not merely a cyclical anomaly but a reflection of broader forces: a broadening market breadth, evolving Federal Reserve policy, and a recalibration of valuation dynamics.

Market Breadth Expansion: A Diversified Rally

The second quarter of 2025 marked a turning point. The Russell 2000 Index, a bellwether for small-cap equities, surged 8.5% in 2Q25, reversing a 10.1% decline from its November 2024 peak [2]. Micro-cap stocks, in particular, outperformed, with the Russell Microcap Index rising 15.5% during the same period [2]. This momentum extended beyond the US: the MSCI ACWI ex-USA Small Cap Index gained 16.9% in 2Q25, underscoring a global appetite for smaller, more agile firms [2].

This broadening rally is driven by sector rotation. Cyclical and rate-sensitive sectors—financials, industrials, and consumer discretionary—have gained traction, reflecting improved economic sentiment. As noted by Schwab Network, August 2025 saw a “stock rally broaden” as investors shifted away from concentrated tech exposure toward a more diversified portfolio of growth opportunities [2]. The S&P 500’s equal-weight index reached an all-time high in August, signaling that the rally was no longer confined to a handful of mega-cap names [1].

Fed Policy and Valuation Shifts: A Tailwind for Small Caps

The Federal Reserve’s cautious approach to monetary policy has been pivotal. In June 2025, the FOMC maintained the federal funds rate at 4.25%–4.50%, but its projections signaled a gradual reduction to 3.6%–3.9% by year-end [4]. This dovish pivot, coupled with the anticipation of a 0.25% rate cut in September (implied by fed funds futures), has created a favorable environment for small-cap stocks. Lower borrowing costs reduce the cost of capital for smaller firms, which often rely more heavily on debt financing than their large-cap counterparts [1].

Moreover, the Fed’s balance sheet adjustments—slowing the pace of securities runoff—have injected liquidity into markets, supporting a broader range of equities [3]. This policy backdrop contrasts sharply with the high-interest-rate environment of 2023–2024, which had disproportionately hurt small-cap valuations. As of July 2025, the S&P 600 Small Cap Index traded at a forward P/E of 15.8, compared to the S&P 500’s 22.48 [1]. The Russell 2000’s EV/EBIT ratio was at a 25-year low relative to the S&P 500, further highlighting its undervaluation [1].

Strategic Implications for Investors

The case for small-cap rotation is reinforced by earnings momentum. Small-cap companies are emerging from an earnings recession, with projected 22% EPS growth in 2025—well above the 15% expected for large-cap firms [1]. This outperformance is particularly evident in non-technology sectors, where small-cap firms are capitalizing on AI-driven productivity gains and improved demand.

However, risks remain. The Fed’s projections hinge on a resilient labor market and moderating inflation, both of which could be disrupted by tariffs or geopolitical shocks [5]. Yet, for investors seeking diversification and value, small caps offer a compelling asymmetry: attractive valuations, earnings upside, and a structural shift in market leadership.

Conclusion

The broadening US equity rally is not a fleeting trend but a recalibration of market dynamics. Small-cap stocks, once dismissed as too volatile or illiquid, are now central to a more diversified and resilient economic expansion. As the Fed navigates a path toward rate cuts and investors rebalance portfolios away from overvalued tech giants, small-cap equities stand to benefit. For those with a long-term horizon, the current valuation gap and earnings momentum present a rare opportunity to participate in a market that is rediscovering its breadth.

Source:
[1] Weekly Market Commentary September 2, 2025 [https://www.breakawaywealth.com/weekly-market-commentary-september-2-2025-9e150]
[2] 2Q25 Small-Cap Recap [https://www.royceinvest.com/insights/small-cap-recap]
[3] Monetary Policy Report – June 2025 [https://www.federalreserve.gov/monetarypolicy/2025-06-mpr-part2.htm]
[4] The Fed - June 18, 2025: FOMC Projections materials, accessible version [https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20250618.htm]
[5] Economic Update Q2 2025 [https://www.oldrepublictitle.com/blog/economic-update-q2-2025/]