For three years, the rally in US equities has been driven by a handful of large caps benefiting from the AI theme.
Meanwhile, small caps have struggled. The US small-cap index, the Russell 2000, is far less exposed to tech.
Over three years, the performance gap has nearly doubled: +39% for the Russell 2000 versus 70% for the S&P 500.
Source: MarketScreener
And large-cap leadership is not new. Over the past ten years, the Russell 2000 has outperformed the S&P 500 only twice (in 2016 and 2020).
This is a performance gap that is somewhat justified. Historically, small caps outperform because smaller companies deliver faster growth than larger ones, whose businesses are more mature.
However, over the past three years, it is the Magnificent 7 that have driven earnings growth, while a big chunk - 40% - of Russell 2000 companies are actually not profitable. More indebted, small caps have been penalized by rising rates.
Recently, the prospect of rate cuts and the pullback in AI names has helped the Russell 2000 make up some ground and nearly match the S&P 500 in 2025.
As everyone looks ahead to 2026, the question now is whether the Russell can outperform the S&P 500 next year.
The macro backdrop looks favorable: Fed rate cuts (three in 2025 and possibly one or two in 2026) should filter through in 2026 and support companies. On the fiscal side, the tax-cut plan passed by Congress this summer will help.
Thus, based on the Fed's economic projections, US growth should reaccelerate next year, from 1.7% in 2025 to 2.3% in 2026.
Russell constituents will benefit all the more as they are more exposed to the US market than S&P 500 names.
Analysts project 35% growth in each of the next two years for Russell 2000 companies, versus 14% for those in the S&P 500. All with a valuation 5% above the S&P 500, compared with a 15% premium historically.
