After years of underperformance, small-cap stocks are gaining ground. Forecasts for 2025 point to 22 percent earnings per share (EPS) growth in the small-cap space, compared to just 15 percent for large-cap companies in the S&P 500, according to Trustnet.

This is more than a rebound. It marks a possible turning point. Investors are beginning to look beyond the AI-driven mega-cap stocks that dominated the last cycle and toward smaller companies that may offer stronger upside from here.

Large caps have led for over a decade, helped by near-zero interest rates and concentrated investor demand. But small-cap stocks are historically cyclical. They tend to outperform when economic conditions stabilize and interest rates peak. Since 1979, small caps have outpaced large caps by an average of seven percentage points in the 12 months following a pause in Federal Reserve rate hikes, based on data from JPMorgan Asset Management.

Now that the Fed is signaling a hold or potential cut, the setup for small caps is starting to look more favorable.

Undervalued and Overlooked

The Russell 2000 is up 6.02 percent year-to-date, edging out large-cap indices in early 2025. This follows a two-year stretch of underperformance, driven by rising borrowing costs and tighter liquidity.

That selloff has left valuations at a deep discount. The Russell 2000 trades at a forward price-to-earnings (P/E) ratio of 15.1, while the S&P 500 sits at 19.6, according to Morningstar. This valuation gap is among the widest in decades, suggesting that small caps are significantly cheaper relative to large caps.

The last time the Fed paused rate hikes in late 2018, the Russell 2000 rallied 22 percent the following year. Today’s setup mirrors that backdrop: rate pressure easing, valuations compressed, and small-cap earnings expected to outgrow the broader market.

Where Growth Is Coming From

Earnings growth is not evenly distributed across sectors. In 2025, the strongest gains are projected in:

• Industrials and energy, supported by infrastructure spending, supply chain reshoring, and higher oil prices
• Consumer discretionary and financials, rebounding as rates stabilize and lending activity improves
• Technology, especially smaller AI and cybersecurity firms innovating at the edge of the sector

Companies like SentinelOne and Cloudflare began as small-cap players and have grown by delivering targeted innovation in areas previously dominated by large tech firms. This underlines a broader point: tech-driven growth is not limited to mega-caps.

Why Wall Street Has Been Late

Despite clear signs of recovery, institutional exposure to small caps remains low. Fund flow data from Goldman Sachs shows hedge funds and asset managers still favor large caps, partly out of habit and partly because of how long the trade has worked.

Retail investors, however, are moving in. Trading volumes in small-cap ETFs are up 18 percent year-to-date, according to MarketWatch. If institutional capital starts rotating in, the upside could grow quickly.

What Needs to Hold

For small-cap stocks to keep gaining, several conditions need to stay in place:

• Interest rates must remain stable or decline. If inflation rises again and the Fed tightens policy, borrowing costs could pressure small businesses
• Economic growth must continue. Small companies are more sensitive to downturns and tend to suffer more during slowdowns

If those two factors remain supportive, small caps are in a strong position to lead on earnings growth in 2025. Investors who wait too long may find themselves chasing returns that are already well underway.