US small-cap stocks surge as rotation from megacap tech and energy gains drives market leadership amid improving earnings cycle

US small-cap stocks are staging a notable comeback in 2026, outperforming their large-cap peers after years of lagging returns, as sector dynamics, valuation resets, and improving earnings prospects reshape market leadership.

So far this year, small caps have outperformed large caps by 8.5 percentage points, marking a sharp reversal after roughly six years of underperformance. The S&P SmallCap 600 Index has gained 6.8% in the year to date, while the S&P 500 is down 0.49% over the same period.

Sector dynamics tilt in favor of small caps

A key driver of the outperformance has been sector composition. Energy, the best-performing sector this year, carries a larger weight in small-cap indices than in large-cap benchmarks.

• Energy accounts for 6.5% of the S&P 600 small-cap index versus 3.5% in the S&P 500.

Smaller energy companies have also proven more sensitive to rising oil prices, amplifying gains. Large-cap energy stocks are up 29% this year, while small-cap energy names have surged 41%, reflecting higher operational leverage to commodity price movements.

At the same time, technology—an important sector in large-cap indices—has underperformed. Information technology makes up roughly a third of the S&P 500 but only 12% of the S&P 600.

The relative weakness in tech, partly linked to concerns around artificial intelligence valuations, has weighed more heavily on large caps. Despite this, small-cap technology stocks have delivered strong returns, creating an unusual divergence. Even excluding the “Magnificent 7” megacap tech stocks, small caps continue to outperform, suggesting broader structural factors beyond sector allocation alone.

Earnings cycle and capital spending boost outlook

Improving earnings momentum is another critical factor supporting small-cap performance. Investors view smaller companies as benefiting from the early stages of a multi-year earnings cycle, supported by capital spending, productivity gains, and reshoring trends.

Francis Gannon, co-chief investment officer and managing director at Royce Investment Partners, said in a BNN Bloomberg report that small caps have strengthened since last year’s market bottom. He noted that the one-year performance is “quite strong,” referencing the market bottom around the “tariff tantrum” on April 8 of the prior year.

Gannon added that the firm expects small caps to be at the beginning of a prolonged period of outperformance, driven by what he described as a “very strong earnings cycle.” He pointed to productivity improvements linked to AI adoption, increased domestic investment, and margin expansion for smaller firms, alongside policy support through tax incentives encouraging capital expenditure.

He also emphasized the role of the investment cycle, citing the “One Big, Beautiful Bill” signed into law last year, which he said includes “100 per cent depreciation on capital expenditures as well as research.” Gannon said this is starting what the firm expects will be a strong CapEx cycle.

Valuations, rotation and market structure support gains

Valuation dynamics are also contributing. Small-cap stocks typically trade at lower multiples than large caps, and that discount has attracted investors looking for opportunities outside crowded megacap trades.

Rotation away from large technology stocks has further supported smaller companies. As investors diversify portfolios and reduce concentration risk, capital has increasingly flowed into under-owned segments of the market.

Gannon said part of the case for small caps is “rotation away from those areas,” adding that the market is “broadening.” He also noted that small caps remain cheaper on a valuation basis than large caps even after gains over the past year, and that the combination of valuation support and the start of a prolonged earnings cycle strengthens the outlook.

Market structure is also shifting. While many smaller companies remain unprofitable, the market is increasingly favoring higher-quality firms with strong earnings and cash flow. Gannon said the firm invests in companies with “earnings, cash flow, and strong fundamentals.”

With small caps benefiting from a mix of cyclical and structural tailwinds—sector weight, improving earnings momentum, and valuation/positioning changes—investors are increasingly focused on the asset class as market leadership evolves.