Why Small Caps' Lagging Performance Isn't a Red Flag for U.S. Equities

The S&P 500's recent resilience has overshadowed small-cap stocks, with the latter lagging behind despite trading at some of the most attractive valuations in decades. Yet, this divergence isn't a warning sign for U.S. equities—it's a buying opportunity. By examining market cycles, valuation discounts, and historical patterns, investors can see why maintaining exposure to small caps is critical for long-term growth.

The Valuation Case for Small Caps

As of mid-2025, small-cap stocks traded at a 17% discount to Morningstar's fair value estimate—one of the steepest gaps relative to the broad market in the past 15 years. This discount isn't an anomaly; it reflects a late-cycle dynamic where large-cap dominance often persists until economic recovery takes hold.

While the S&P 500 has held near its peak, fewer than 52% of its constituents are above their 200-day moving average, signaling weakening breadth. This “dwindling participation” historically precedes near-term declines, yet small caps—despite their undervaluation—are held back by short-term factors like monetary policy expectations and economic growth trends.

Market Cycles and the Small-Cap Rebound

Small-cap performance often lags during late-cycle rallies but historically outperforms in recovery phases. The Federal Reserve's projected two rate cuts in 2025 and falling long-term interest rates will likely create a tailwind for small caps, which thrive in environments of Fed easing and improving economic conditions.

Morningstar's outlook suggests the economy will rebound by early 2026, aligning with the typical small-cap outperformance window that follows recessions or slowdowns. Investors who sell small caps now risk missing this cyclical shift.

Sector-Specific Opportunities

Within small caps, select sectors offer compelling value. Healthcare and energy are standouts:
- Thermo Fisher Scientific (TMO): A 5-star Morningstar rating reflects its dominance in life sciences tools and undervalued intrinsic worth.
- Exxon (XOM): Leveraging its energy transition initiatives and strong balance sheet, XOM's valuation gap suggests upside potential.

Conversely, overvalued sectors like financials and consumer defensives—where stocks trade at 18% premiums—should be trimmed to rebalance portfolios.

Building Resilience Through Diversification

The current environment demands a strategic rebalance:
1. Reduce exposure to overvalued growth stocks, which face heightened volatility tied to tariff deadlines and earnings disappointments.
2. Reinvest proceeds into small-cap value stocks, which offer a 12% discount to their fair value and are poised to benefit from Fed easing and economic recovery.

Conclusion: Patience Pays

The S&P 500's recent strength isn't a sign of broader market health but a symptom of late-cycle momentum. Small caps' lag is temporary, not terminal. Their valuation discounts and cyclical tailwinds position them as the next leg of the equity rally.

Investors who maintain exposure to small-cap value stocks—while trimming overvalued sectors—will be well-positioned to capture the upside once the cycle turns. The message is clear: undervaluation is the foundation of future returns.

This analysis synthesizes valuation metrics, historical cycles, and macroeconomic trends to argue for a disciplined, long-term approach to small-cap exposure.