As global markets navigate uncertain waters, an extended cycle of underperformance has emerged in the small-cap universe. Investors, in search of safe harbors, have flocked to large-cap stocks, leaving smaller companies adrift.

Understanding the Performance Divide

Since around 2011, large-cap equities have enjoyed a remarkable run of outperformance over their smaller counterparts. This significantly lagged large caps cycle has now lasted 13–14 years, exceeding the historical average of 11–12 years.

The small-cap benchmark (Morningstar US Small Cap Extended Index) plunged 23% from its postelection high on November 25, 2024, to April 4, 2025, officially entering bear market territory for small caps. The last time small caps showed clear dominance was in 2016, marking a nearly decade-long drought.

Key Drivers of Recent Underperformance

Multiple factors have conspired to weigh on small-cap returns, creating a challenging environment for investors who seek growth from these nimble enterprises:

• Economic sensitivity in late-cycle phases: Smaller firms often lack the diversified revenue streams of large corporations, making them vulnerable when growth slows.
• Higher leverage and interest rate exposure: Many small companies carry floating-rate debt, which expands interest costs as rates rise.
• Shifts in quality composition: A surge of lower-quality issuers has entered the public markets, diluting the small-cap index.
• Delayed public offerings of top startups: Promising ventures remain private longer, leaving fewer high-potential names in the small-cap pool.

This combination of financial fragility and strategic timing has amplified the performance gap between market-cap segments.

Investor Psychology and the Search for Stability

Amid global uncertainty—from pandemic recoveries and inflation spikes to geopolitical tensions—investors have gravitated toward established, profitable enterprises. The so-called “Magnificent Seven” tech giants drove much of the large-cap rally, delivering roughly 30% earnings growth in 2024.

With earnings growth projected to slow to around 20% in 2025, some market watchers warn that valuations may become stretched. Yet the allure of steady, predictable cash flows remains strong, as risk-averse investors prioritize balance-sheet strength.

Valuation Gaps and Implications

Small caps now trade at near-record lows relative to the S&P 500, based on metrics like price-to-earnings and price-to-book ratios. In contrast, large caps sit at elevated valuations driven by robust demand from safety-seeking market participants.

These valuation disparities hint at the potential for improved small-cap performance if macro conditions stabilize or if large-cap profit growth decelerates.

Potential Catalysts for a Small-Cap Turnaround

Several trends could spark a rotation back into smaller equities:

• Earnings growth acceleration in 2025: Analysts forecast small-cap earnings shifting from negative to double-digit positive territory.
• Macro stabilization signals: Easing inflation, plateauing rates, or clear economic expansion could reduce risk premiums.
• Valuation realignment: As large-cap multiples compress, relative value may draw capital toward underpriced small names.

Historical precedents show that after extended periods of dominance by one market segment, capital often rebalances toward the unloved alternative.

Risks and Cautions

Despite the appeal, small-cap investing carries inherent risks:

• Higher volatility and wider performance dispersion among individual names.
• Greater exposure to economic downturns and sector-specific challenges.
• Potential for credit stress in companies with weak balance sheets.

Active management can help navigate these risks by identifying high-quality opportunities and avoiding weaker issuers within the small-cap universe.

Portfolio Construction Insights

Including a thoughtfully sized allocation to small and mid caps can enhance diversification and long-term return potential. Consider these principles:

• Balance risk with position sizing to limit the impact of individual security swings.
• Focus on quality and cash-flow metrics to screen for resilient businesses.
• Maintain flexibility to adjust exposure as market cycles evolve.

Investors may also explore smid-cap or value-focused strategies to capture targeted segments that exhibit lower valuations and potential for recovery.

Conclusion: Preparing for the Next Market Phase

Small caps have faced a protracted period of underperformance, driven by cyclicality, leverage pressures, and investor risk aversion. Yet the very forces that depressed valuations may sow the seeds for a future rebound.

By understanding the drivers behind the small-cap lag, recognizing valuation gaps, and adopting disciplined portfolio approaches, investors can position themselves to benefit when the cycle turns. With earnings momentum poised to improve and large-cap multiples potentially overextended, a carefully timed rotation could reward those who stay the course.

Embracing the long-term performance advantage traditionally associated with small caps may require patience, but history suggests that opportunity often emerges when it is least expected.