After years of underperformance, small-cap stocks have gotten off to a strong start in early 2026. Though the new year has just begun, one of the most notable stories in the stock market so far has been the breakout performance of the small-cap index, the Russell 2000. In fact, during the first 14 trading days of the year, the Russell 2000 outperformed the S&P 500 index each day—a winning streak that was broken on January 23rd when the Russell 2000 fell nearly 2%.
Nevertheless, over the first three weeks of the year, the small-cap index has established a significant lead over its large-cap counterpart.
Over the past five years, the S&P 500 has outperformed the Russell 2000 each year and maintained its leadership throughout the recent three-year artificial intelligence boom. However, thanks to its strong start this year, the Russell 2000 appears poised to finally beat the S&P 500 in 2026. There are two main reasons for this:
After cumulative gains of over 75% in the past three years, the S&P 500’s valuation is approaching its historical peak. ETFs tracking the S&P 500 show a price-to-earnings ratio of 28x. Concerns about an AI bubble, the high concentration of the “Magnificent Seven” (which currently account for about one-third of the index’s weighting), and expectations for a broadening of the bull market are all driving funds toward alternatives like small-cap stocks.
The largest Russell 2000 ETF by size—the iShares Russell 2000 ETF—currently trades at a P/E ratio of 19.5x, representing a discount of approximately one-third compared to the S&P 500. In other words, the Russell 2000 would need to rise about 50% to reach a valuation level comparable to the S&P 500. This gap is likely to fuel a rotation of funds from large-cap to small-cap stocks.
Small-cap stocks are more sensitive to macroeconomic factors, particularly interest rates. Indeed, with the Federal Reserve cutting rates three times at the end of last year, lowering the benchmark federal funds rate by 75 basis points, the Russell 2000 has surged 17% over the past six months.
Although the Fed currently projects only one more rate cut this year, the actual number of cuts this year may exceed expectations. This is due to near-stagnant job growth over the past eight months, the arrival of a new Fed Chair in May, and pressure from President Trump on the central bank to cut rates (potentially leading to the appointment of officials more inclined toward easing). Further rate cuts—especially those not anticipated by the market—could prove even more favorable for small-cap stocks.
The most convenient way to gain exposure to small-cap stocks is through ETFs that track the Russell 2000. The largest such ETF, the iShares Russell 2000 ETF (IWM), has approximately $75 billion in net assets. For investors seeking a focus on either growth or value stocks, more targeted ETFs are available, such as the Vanguard Russell 2000 Growth ETF (VTWG) or the Vanguard Russell 2000 Value ETF (VTWV).
Investors can also consider individual small-cap stocks. Digital product analytics software developer Amplitude (AMPL) is poised for a potential breakout in 2026; its series of AI agents launched last year is expected to drive accelerated growth this year. Another option is data annotation specialist Innodata (INOD), whose business is a crucial link in helping AI process data more efficiently. The company is already experiencing strong growth and sustained profitability.
Although the Russell 2000’s early-year winning streak may be difficult to sustain, small-cap stocks are well-positioned for a potential breakthrough this year. Whether through ETFs or individual stocks, investors have multiple ways to capture the anticipated market rotation opportunity.
