Small Caps Are the Main Character: Tracking the 2026 Rotation via Search & Flows

The market's mood has shifted. After a year dominated by a handful of mega-cap tech giants, a tangible rotation is taking hold. The numbers show a clear reversal: the Russell 2000 is up 5.57% year-to-date, while the S&P 500 has gained just 0.56%. This is a stark pivot from 2025, when large caps led the rally. As State Street's chief investment strategist Michael Arone observes, the market is showing hints of a rotation early this year, with momentum building from the end of last year.

Tech, the standout performer in 2025's AI boom, is now stumbling. The sector is the worst performer so far this year, losing 0.40%. This sets the stage for small caps to become the main character. The rotation appears to be broadening, with small-cap companies showing the strongest returns growth across both value and growth indexes. The catalyst here is earnings. As Arone notes, the gap between technology earnings growth and the rest of the market is closing, making a wider range of stocks attractive.

The sustainability of this trend is the key question. Arone points to a powerful setup: a stronger-than-expected economy supported by fiscal and monetary stimulus, combined with broadening earnings growth. If that "one-two punch" continues, the rotation could sustain momentum for quarters. For now, the search volume and capital flows are clearly shifting, marking a significant change in the market's headline.

Is This the Main Character? Tracking Search Volume and Market Attention

The rotation is no longer just a whisper in the financial press. It's becoming a headline, and the market's search volume is spiking to match. In January, interest in terms like "small cap stocks" and "Russell 2000" has surged, indicating a viral sentiment is taking hold among retail investors. This isn't just institutional positioning; it's a public conversation. When a market theme starts trending on Google, it often signals the beginning of a broader, more populist rally. The risk, of course, is that this can amplify volatility if the sentiment turns quickly.

Institutional capital is already lining up. The iShares Russell 2000 ETF (IWM), the primary vehicle for small-cap exposure, holds assets of nearly $76.8 billion. That massive pool of money shows the rotation has institutional credibility and depth. Technical charts for IWM are painting a bullish picture, with analysts spotting completed cup-and-handle patterns and targeting highs near $300. This blend of high search volume and deep ETF flows suggests the rotation has the ingredients for a sustained move.

Yet, for this to be more than a fleeting trend, it needs broad-based momentum. The real test is in the daily trading action. We need to watch the average daily volume across the Russell 2000 index and its constituent stocks. If the rotation is broad, we should see volume expand beyond a handful of popular names. Right now, the focus is on a few hot trades, like Opendoor Technologies and NuScale Power, which are seeing high volume and institutional accumulation. But a true rotation would see volume pick up across the board, from industrials to consumer discretionary. Without that, the rally risks being limited to a few viral stories, leaving the broader small-cap universe behind.

The bottom line is that the rotation has the hallmarks of a trending topic: rising search interest, significant capital flows, and bullish technical setups. It's the main character in the current news cycle. But for it to stay in the lead, the momentum must broaden beyond the headlines and into the daily trading patterns of thousands of small-cap stocks.

Why Small Caps? The Fading AI Narrative and Policy Tailwinds

The rotation from mega-caps to small caps isn't random; it's a direct response to shifting market catalysts. The most immediate trigger is the fading of the AI investment boom. Tech, which was the standout performer in 2025, is now the worst sector so far this year, losing 0.40%. This slump is a clear sign that the earnings growth engine fueled by massive AI spending is cooling. As State Street's Michael Arone notes, the gap between tech earnings growth and the rest of the market is closing. That's the core catalyst for the rotation: when the AI narrative loses steam, capital naturally flows to areas where earnings are broadening, like small-cap companies.

This shift is being amplified by powerful policy tailwinds. The market is betting on a "stronger-than-expected" economy supported by fiscal and monetary stimulus. For small caps, which are more sensitive to domestic economic cycles and credit conditions, this is fuel to the fire. The expectation of steady Fed policy and continued stimulus creates a favorable backdrop. It lowers borrowing costs for these smaller, more leveraged firms and boosts consumer spending, which benefits many small-cap industries from retail to industrials.

Historically, this rotation makes sense. The current 15-year streak of large-cap outperformance is an anomaly. Over any 10-year window, small caps beat large caps two-thirds of the time. The market is essentially resetting after a prolonged period of dominance by a few mega-caps. This isn't just a tactical trade; it's a cyclical reversion to a longer-term norm. The setup now combines a fading AI narrative, supportive policy, and a valuation gap-three tailwinds converging to make small caps the main character in 2026.

The Catch: Valuation, Volume, and What to Watch

The rotation has momentum, but it's not without its risks. The main character in this story is still a reversal of underperformance, not a new era of dominance. The Russell 2000's 12% gain last year still lagged the S&P 500's 17% rise. This sets the stage: the rotation is a catch-up play. For it to become a sustainable trend, the rally needs to outpace the broader market, not just close a gap. The risk is that this is a headline-driven sentiment shift, vulnerable to any change in the macro or policy narrative.

The biggest headline risk is a shift in Fed communication. The rotation is being fueled by expectations of steady policy and stimulus. If the Fed signals a pivot away from its current stance, or if economic data suddenly weakens, the entire setup could unravel quickly. This is the classic "catalyst" that can reverse a trend. The market's search volume and ETF flows are impressive, but they can be fickle. When a theme goes viral, it can also fade fast if the underlying fundamentals don't support it.

So, what are the key watchpoints? First, monitor the IWM ETF flows. The fund holds nearly $76.8 billion, a deep pool that can sustain momentum. But watch for any signs of outflows, which would signal institutional doubt. Second, track Russell 2000 trading volume. The rotation needs to broaden beyond a few viral stories like Opendoor or NuScale. If average daily volume across the index expands, it confirms the move is gaining real participation. If volume stays concentrated, the rally may lack staying power. Finally, listen for any shift in the Fed's messaging. A change in tone from dovish to cautious would be the most direct catalyst for a reversal.

The bottom line is that the rotation has all the ingredients for a trending topic: strong sentiment, capital flows, and technical setups. But for it to be more than a short-lived bounce, it needs to prove its breadth and resilience against the next major headline. Watch the flows, the volume, and the Fed's words.