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In the first half of 2025, investors witnessed a stark divergence between small capitalization stocks and their larger counterparts. With markets swirling from macroeconomic pressures and a concentrated rally in mega-cap technology names, smaller firms found themselves increasingly sidelined. This article delves into the latest performance data, examines the historical context, and outlines potential catalysts that might spark a turnaround. Read on for practical insights that can help shape your portfolio strategy.
Small caps experienced a pronounced decline in the first quarter of 2025. The Russell 2000 Index registered a -9.5% return, compared to a -4.5% decline for the Russell 1000 Index over the same period. Meanwhile, the S&P 500 slipped by -1.74%, and the NASDAQ 100 outperformed with modest losses, setting the stage for a widening performance gap.
Year-to-date through June, large caps continued to outshine their smaller peers. The S&P 500 and NASDAQ 100 outpaced small caps by approximately 16% and 18%, respectively. As a result, more than half of the positive returns in the S&P 500 stemmed from just four mega-cap names, creating a “top-heavy” market dynamic.
In the second quarter, value-oriented sectors—including some small and mid-cap names— recorded gains of 4.59%. However, this moderate advance did little to close the broader underperformance gap, as large-cap resilience outside the AI and growth segments further widened the divide. Bonds and non-US equities also experienced strong inflows, underscoring the search for stable alternatives amid heightened volatility.
Multiple factors have weighed on small-cap stocks. Higher interest rates have disproportionately impacted smaller firms, which often rely on borrowing to fund growth. In addition, economic uncertainty and a slower earnings recovery have undermined investor confidence in less capitalized companies. Finally, a meteoric rally among mega-cap technology names created an uneven market disparity that left smaller stocks trailing.
Amid these headwinds, small caps struggled to find a sustainable bid, entering a bear market after falling over 23% from postelection highs. For many market participants, the lack of rotation into smaller names signaled deep-rooted challenges for this asset class.
Small-cap underperformance is not a new phenomenon. Over the past decade, small caps have trailed large caps by roughly 5 percentage points annually, all while exhibiting higher volatility. We are currently in the 14th year of a large-cap outperformance cycle, exceeding the historical average of 11 years.
The last year that small caps meaningfully outperformed was 2016. Academic research suggests that a “small-cap premium” exists, rewarding investors for bearing greater risk. However, the extended duration of large-cap dominance has challenged this traditional view, leading some analysts to conclude that the cycle may soon invert.
As legendary market strategist Jeremy Siegel has observed, “Valuation mismatches often precede dramatic shifts in leadership.” With small caps trading at steep discounts, history suggests that patient capital can be rewarded when sentiment ultimately turns. Yet investors must remain disciplined, as the timing and magnitude of any reversal can be unpredictable.
On a valuation basis, small caps now appear attractively priced relative to both historical norms and large-cap peers. Many strategists highlight that the significant discount offers a compelling entry opportunity. While the market may require patience, the disparity has reached levels that often precede a reversal in leadership.
Institutional managers argue that the extended large-cap cycle is unsustainable indefinitely. With interest rate expectations possibly peaking and geopolitical considerations shifting toward domestic initiatives, small-cap stocks could become beneficiaries of a risk-on environment in the coming quarters.
For investors considering small-cap exposure, a thoughtful approach is crucial. Timing market rotations can be challenging; instead, building gradual positions around periods of market stress may yield better outcomes. Dollar-cost averaging into small-cap funds or ETFs can mitigate the risk of entering at an inopportune moment.
Ultimately, small caps should be viewed as a component of a broader portfolio. While they carry greater risk, they also offer enhanced long-term growth potential and diversification benefits when combined with large-cap holdings and fixed-income allocations.
Understanding that market cycles ebb and flow can help investors remain calm during periods of underperformance. By keeping focus on fundamental valuations and prospective catalysts, it is possible to position for future recoveries without succumbing to short-term volatility.
Looking ahead, tracking breadth indicators, credit spreads, and real economic data will be essential for assessing whether small caps can earn back their historically higher risk premiums.
The divergence between small and large-cap performance in the first half of 2025 highlights both risks and opportunities within equity markets. While small caps have suffered a steep drawdown, their valuation appeal and potential for a cyclical rebound should not be overlooked. Investors armed with a disciplined strategy and an eye on policy shifts may find that patience and prudence lead to attractive rewards as market leadership inevitably rotates.
As we navigate an environment marked by macroeconomic uncertainty and lingering market concentration, maintaining a balanced perspective remains key. Whether small-cap stocks reclaim their historical premium or continue to lag, incorporating them wisely can enhance portfolio resilience and long-term returns.
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