The Small-Cap Reawakening: Catalysts for a Market Re-Rating in 2025

The U.S. stock market’s momentum has hit a crossroads in 2025. While large-cap benchmarks like the S&P 500 have stagnated amid macroeconomic headwinds, small-cap stocks have defied expectations, surging nearly 20% year-to-date. This divergence raises a critical question: Can the forces driving small-cap outperformance—namely, easing monetary policy, aggressive buybacks, and a surge in takeover activity—spark a sustained re-rating of smaller companies?

Challenges to Market Momentum: The Stagnation of Large-Cap Dominance

Large-cap stocks, once the bedrock of market growth, now face structural headwinds. Stagflationary risks—characterized by weak growth and persistent inflation—have eroded profit margins, particularly for growth-oriented sectors like technology and consumer discretionary [1]. Meanwhile, the transition of mega-cap stocks from “pure growth” to “partial value” classifications has dampened their outperformance, as investors recalibrate expectations for slower earnings expansion [5].

Corporate buyback activity, a traditional driver of large-cap momentum, has also shown signs of fatigue. While S&P 500 companies executed a record $942.5 billion in buybacks in 2024, early 2025 saw a pullback, with Q1 executions trailing seasonal norms [2]. Elevated valuations and the 1% excise tax on buybacks under the Inflation Reduction Act have further constrained large-cap firms’ ability to deploy capital effectively [1].

Catalysts for Small-Cap Revival: A Perfect Storm of Valuation, Policy, and M&A

Small-cap stocks, by contrast, are positioned to capitalize on a confluence of favorable conditions.

1. Easing Monetary Policy and Rate Cuts
The Federal Reserve’s anticipated rate cuts in 2025 have become a tailwind for small-cap equities. These companies, often more sensitive to interest rate changes, thrive in environments of declining borrowing costs and economic reflation. As of August 2025, small-caps traded at a 15% discount to fair value, a historically attractive entry point [1]. Analysts project 30% annual earnings growth for small caps through 2026, driven by domestic reshoring and infrastructure investments [4].

2. Buyback and Takeover Surge
Small-cap companies have leveraged their undervalued status to execute aggressive buybacks. For example, Saturn Oil & Gas repurchased 3.31% of shares for $14.9 million in early 2025, while Ready Capital spent $37.48 million on 8.5 million shares in Q2 [2][3]. These programs signal confidence in intrinsic value and have contributed to a record $926 billion in year-to-date buyback announcements [3].

Takeover activity has further amplified momentum. UK corporates and private equity firms have targeted small- and mid-cap firms, with over 40% of UK takeover offers in H1 2025 directed at this segment [1]. Strategic bidders, including those in technology and industrials, are leveraging strong balance sheets to drive re-ratings [4].

3. International Tailwinds
Global fiscal stimulus and currency dynamics have bolstered small-cap performance abroad. Developed and emerging-market small-caps surged over 20% in H1 2025, supported by European fiscal packages and a weakening U.S. dollar [6]. This international strength underscores small-caps’ potential to diversify portfolios beyond U.S. market stagnation.

Contrasting Trajectories: Why Small-Caps Outperform

The contrast between small- and large-cap trajectories is stark. While large-cap stagnation reflects macroeconomic fragility and capital allocation constraints, small-caps benefit from a unique alignment of valuation, policy, and corporate action. Their lower multiples and higher growth potential make them ideal candidates for re-rating in a post-stagflation environment.

However, risks remain. Rising trade tensions and policy uncertainties could disrupt momentum [3]. Yet, with the Fed poised to cut rates and global economic reflation gaining traction, the case for small-caps grows compelling.

Conclusion: A Multi-Year Re-Rating in the Making

The 2025 small-cap rally is not a fleeting anomaly but a structural shift. As buybacks, takeovers, and rate cuts converge, smaller companies are primed to outperform in a market increasingly skeptical of large-cap complacency. For investors, the key lies in identifying catalysts—whether sector-specific M&A trends or valuation-driven buybacks—that can unlock multi-year gains.

Source:
[1] September 2025 Stock Market Outlook: Will the Small-Cap [https://www.morningstar.com/markets/stock-market-outlook-where-we-see-investing-opportunities-september]
[2] Takeovers: Trends in 2025 [https://www.slaughterandmay.com/insights/horizon-scanning/takeovers-trends-in-2025/]
[3] Top Undervalued Small Caps With Insider Activity In ... [https://finance.yahoo.com/news/top-undervalued-small-caps-insider-113933340.html]
[4] Small-Cap Stocks: Positioned for a Comeback in 2025 [https://spotlightgrowth.com/small-cap-stocks-positioned-for-a-comeback-in-2025/]
[5] Key mega-caps move from pure growth to partial value [https://www.lseg.com/en/insights/ftse-russell/key-mega-caps-move-from-pure-growth-to-partial-value-2025-russell-recon-style-shifts]
[6] Quarterly Market Outlook — third quarter 2025 [https://www.edwardjones.com/us/en/market-news-insights/stock-market-news/quarterly-market-outlook]