Small-cap stocks have had a rough start to 2025. After rallying late last year on hopes of a soft landing and easing rates, the Russell 2000 turned sharply in February. It’s now more than 10% off its November highs—officially in correction territory.

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That reversal caught a lot of investors off guard. These were supposed to be the comeback story of the year: undervalued, underloved, and ready to benefit from a broadening market recovery. Instead, the index slipped into a familiar pattern—volatility fueled by interest rate anxiety, inflation fears, and broader macro uncertainty.

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Why the Drop?

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None of this is happening in a vacuum. Small-cap stocks are especially sensitive to interest rate shifts, and the Fed has offered few clear signals about its path forward. While rate cuts were expected earlier this year, recent commentary has taken on a more cautious tone. Mixed economic data and persistent inflation pressures have only added to the uncertainty.

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At the same time, consumer behavior is shifting. After two years of aggressive post-pandemic spending, U.S. households are starting to pull back. For smaller companies that rely on steady consumer demand, that’s a headwind they can’t ignore.

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But as with every broad-market selloff, the story isn’t all bad. These pullbacks often shake out speculative money and leave behind overlooked value. And there are signs that long-term investors are already starting to step back in.

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Where the Value Might Be

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History shows that sharp declines in the Russell 2000 often lead to equally sharp rebounds. After falling nearly 40% in early 2020 during the pandemic shock, the index more than doubled over the next 12 months. Even in 2022, when the Fed’s rapid rate hikes hit growth stocks hard, small-caps managed to recover ground once policy stabilized.

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Today, certain corners of the market look particularly interesting. Small-cap energy names have been quietly resilient, even as oil prices fluctuate. Regional banks, hit hard during last year’s banking crisis, are starting to show signs of stabilization. And biotech, while always volatile, has historically delivered outsized gains for investors who time it right.

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Institutional investors haven’t walked away. Hedge funds that moved into small-caps last year are still active—they’re just waiting for better entry points.

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A Test of Patience

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Volatility in small-caps is nothing new. These companies don’t have the balance sheets or scale of the mega-caps, which makes them more vulnerable in uncertain environments. But that’s also what makes them compelling during moments of market stress.

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When sentiment turns overly negative and headlines focus on fear, long-term investors often find value hiding in plain sight.

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Small-caps may not bounce back overnight, but the conditions that made them attractive in late 2024 haven’t disappeared. If anything, a market-wide overreaction might be creating the kind of entry points that don’t come around often.

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If you’re looking for stability, treasuries are still there. But if you’re playing for growth and you’re willing to tolerate some short-term pain, this might be one of the more interesting setups small-cap investors have seen in a while.

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