The Overlooked Strength of Small- and Midcap Stocks in a Bull Market

In a market where the S&P 500 has become a symbol of complacency, investors may be missing a critical opportunity: the overlooked strength of small- and midcap stocks. While the S&P 500's year-to-date gains in 2025—driven by a handful of “Magnificent Seven” tech giants—have dominated headlines, the Russell 2000 (IWM) has quietly shown signs of resilience and potential. This divergence raises a compelling question: Is it time to rebalance portfolios to capitalize on the underappreciated momentum in the small-cap segment?

The S&P 500's Narrowing Bull Market

The S&P 500's 5% year-to-date return in 2025 is impressive, but it masks a troubling trend. Over 80% of this gain has been driven by just five stocks—Meta, Apple, Amazon, Microsoft, and Nvidia. These names, with their dominant market shares and AI-driven growth narratives, have created a “winner-takes-all” dynamic. Meanwhile, the Russell 2000, which tracks smaller, more economically sensitive companies, has lagged, falling 1% year-to-date. Yet, this underperformance may be a mispricing opportunity rather than a sign of weakness.

Small-Cap Resilience Amid Volatility

Despite a 21% bear market decline in the first half of 2025, the Russell 2000 has rebounded, recovering much of its lost ground. Historical data reveals that the index has averaged a 60% return in the year following a bear market trough over the past two decades. This pattern suggests that small-cap stocks, while more volatile, often outperform in extended bull markets when macroeconomic conditions stabilize.

The current environment is not without challenges. Rising interest rates, trade policy uncertainties, and inflationary pressures have made small-cap stocks more sensitive to economic shifts. However, these same factors have pushed valuations to historically attractive levels. The Russell 2000 trades at a 25% discount to the S&P 500 on price-to-sales and price-to-book ratios, and its dividend yield is 1.5% higher. These metrics hint at undervaluation in a sector that typically benefits from economic expansion.

Options Activity Signals Institutional Interest

Recent options trading data underscores growing institutional interest in small-cap exposure. A $3.6 million sweep order for IWM's 218-strike call options—executed just days before the July 2025 expiration—indicates aggressive bullish positioning. The trade's high volume-to-open-interest ratio (8.86) suggests fresh capital entering the market, not just the closure of existing positions. Similarly, a $1.2 million at-the-money call option sweep for the 215-strike level further reinforces this narrative.

Rebalancing for a Broadening Bull Market

The S&P 500's dominance is a red flag for long-term investors. When a narrow group of stocks drives most of the market's gains, it often signals a market nearing a turning point. History shows that small-cap stocks tend to outperform in the later stages of bull markets, particularly when earnings growth accelerates and economic momentum builds.

For investors seeking to rebalance their portfolios, increasing exposure to the Russell 2000 through ETFs like IWM could offer asymmetric upside. While small-cap stocks are inherently more volatile, their potential for outperformance in a broadening market justifies a strategic allocation. A 10–15% allocation to small-cap equities, hedged with defensive sectors or options strategies, could balance risk while capturing growth opportunities.

The Risks and the Road Ahead

No investment strategy is without risks. Small-cap stocks remain vulnerable to rising interest rates and economic slowdowns. A Fed pivot to tighter policy or a trade war escalation could reignite volatility. However, the current macroeconomic landscape—marked by easing inflation, dovish Fed signals, and a potential global growth rebound—favors small-cap resilience.

Investors should also monitor technical indicators. The Russell 2000's 20-day moving average crossing above its 50-day average (a bullish crossover) and its 30-day options skew hitting 72%—a strong bullish signal—suggest near-term momentum is building.

Conclusion: Time to Reassess Complacency

The S&P 500's dominance has created a market complacency that underestimates the potential for a broader-based rally. By rebalancing portfolios to include small- and midcap stocks, investors can tap into a segment with historically strong recovery patterns and attractive valuations. While caution is warranted in a volatile environment, the Russell 2000's momentum—backed by both technical and fundamental indicators—deserves a closer look.

As the bull market matures, the key to long-term success may lie not in chasing the “Magnificent Seven,” but in recognizing the overlooked strength of the companies that drive economic growth from the ground up.