The Case for Small-Cap and Sector-Specific Exposure in a Shifting Policy and AI-Driven Landscape

The U.S. equity market has entered a pivotal phase, marked by divergent performance between large-cap benchmarks and small-cap/value stocks, alongside transformative policy shifts and the accelerating economic impact of artificial intelligence (AI). For investors, this environment demands a strategic reevaluation of asset allocation, emphasizing small-cap equities and sector-specific opportunities in defense, housing, and AI-driven industries.

Small-Cap and Value Stocks: A Tale of Two Halves

The Russell 2000 and S&P SmallCap 600 indices have historically lagged behind the S&P 500, driven by a decade-long dominance of large technology stocks. As of October 2025, the S&P 600 traded at a forward price-to-earnings (P/E) ratio of 16x, compared to the S&P 500's 24x, reflecting a valuation discount for small-cap stocks. However, the second half of 2025 brought a notable shift. The Russell 2000 surged 37.8% from its April 8 low, outperforming the S&P 500 by 4.5% through September 25. This rally was fueled by Federal Reserve rate cuts and improved earnings forecasts, with the S&P 600 projected to deliver 21.2% earnings growth in 2026-well above the S&P 500's expected growth.

While broader small-cap indices like the Russell 2000 remain challenged by high valuations its trailing P/E of 62.43 reflects inclusion of unprofitable companies, quality-screened benchmarks such as the S&P 600 offer compelling value. These indices, which prioritize profitability, have historically outperformed the Russell 2000 in 80% of three-year periods. For investors, this suggests a strategic tilt toward small-cap indices with rigorous quality filters, particularly as earnings momentum builds in 2026.

Policy-Driven Dislocations: Defense and Housing Sectors

U.S. policy shifts in 2023–2025 have created asymmetric opportunities in defense and housing. The FY2025 federal budget allocated $201.9 billion for research and development (R&D), a 4% increase from FY2024, with a significant portion directed toward national defense and advanced technologies. While the exact defense allocation remains unspecified, this funding underscores the government's commitment to maintaining technological superiority, benefiting defense contractors and R&D-focused firms.

In housing, state-level reforms have gained momentum to address affordability crises. Texas, Florida, and New Hampshire, among others, enacted policies to reduce regulatory barriers, such as lowering minimum lot sizes (e.g., Texas's SB 15) and permitting mixed-use developments (e.g., Florida's Live Local Act). These reforms are expected to boost housing supply and reduce costs, creating tailwinds for construction, real estate, and infrastructure firms. For example, Iowa's legalization of accessory dwelling units (ADUs) and Kansas's 60-day permit approval deadlines for single-family homes signal a broader trend toward streamlining development. Investors should monitor states with aggressive pro-housing agendas, as these markets may outperform in the coming years.

AI as a Macroeconomic Catalyst

Artificial intelligence has emerged as a cornerstone of economic growth, with its impact accelerating in 2023–2025. In the first half of 2025 alone, 92% of U.S. GDP growth was attributed to AI data center investments and supporting technologies. Enterprise adoption of generative AI (GenAI) has surged, with 65% of companies regularly utilizing the technology as of 2025-up from 33% in 2023. Private investment in GenAI reached $33.9 billion in 2024, a 18.7% increase from 2023.

The economic benefits of AI are beginning to materialize, albeit unevenly. For instance, 71% of companies using AI in marketing and sales reported revenue gains in 2024, while 49% of those in service operations saw cost savings. Long-term projections suggest AI could boost productivity and GDP by 1.5% by 2035, 3% by 2055, and 3.7% by 2075. The U.S. has solidified its leadership in AI investment, outpacing China and the EU by significant margins. Sectors poised to benefit include semiconductors, cloud computing, and cybersecurity, where AI-driven innovations are reshaping competitive dynamics.

Strategic Allocation in a Fragmented Market

The interplay of policy-driven dislocations and AI-driven growth necessitates a nuanced approach to asset allocation. Small-cap stocks, particularly those in the S&P 600, offer undervalued exposure to earnings growth and economic recovery. Defense and housing sectors present sector-specific opportunities tied to regulatory tailwinds, while AI-driven industries represent long-term growth engines.

For investors, the key is to balance short-term tactical shifts (e.g., rate-sensitive small-cap rallies) with long-term structural trends (e.g., AI adoption). Overweighting quality small-cap indices, selectively investing in defense R&D and pro-housing states, and allocating to AI infrastructure and applications can position portfolios to capitalize on the evolving macro and tech landscape.