Sizing up small caps

July 21, 2026

Time to Read: 3 mins

Small caps have outperformed this year despite the threat of higher interest rates, suggesting the rally is being driven by more than just diversification away from large cap tech stocks. Improving earnings expectations and a resilient U.S. economy support our view that small caps have further upside from here.

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Despite the risk that war-driven energy inflation could keep interest rates higher for longer — or cause the Federal Reserve to tighten monetary policy — small cap stocks have been among the best-performing asset classes year to date. That is especially notable because small caps are typically one of the most interest-rate-sensitive areas of the market.

While some investors are using small caps to diversify beyond crowded large cap tech leadership, the fundamentals also appear to justify the rally. After a period of negative earnings growth in 2023 and 2024, small cap earnings growth recovered to 14% in 2025 and is expected to accelerate to 20% this year and 18% next year. That trajectory demonstrates a meaningful rebound in profit growth and supports the case for higher valuations. Small caps also continue to benefit from a resilient U.S. economy because of their more domestic orientation.

We therefore believe small caps have further upside from current levels. While rate volatility remains a risk, improving earnings and a broadening market backdrop should continue to support the group. As a result, we advise clients to consider adding exposure to small cap companies within a globally diversified equity allocation.

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Not in a bubble

As the S&P 500 approaches all-time highs, there are renewed concerns among investors about elevated valuations. However, historically strong profitability and expected earnings growth appear to support current pricing. In addition, the current S&P 500 price-to-earnings (P/E) ratio is roughly equal to the average since Covid. As a result, we do not view U.S. equities as being in bubble territory and we remain constructive on the asset class.

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Is the market rally broadening?

Stocks, as measured by the S&P 500, are up over 13% through early August. The solid gains have been fueled by a resilient economy, steady consumer spending, optimism around artificial intelligence and better-than-expected earnings growth. Still, some investors worry the advance may be too concentrated in technology and that AI-capex monetization may fall short of expectations. A closer look suggests that it is not just tech moving the market higher.

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Fed friction?

Markets are navigating tensions between a Fed that offers less guidance and an inflation backdrop that remains sticky. Added uncertainty from Middle East tensions and energy-price swings is further shaping sentiment, with recent moves in Treasury yields suggesting the market wants the Fed to hike. However, with yield volatility expected to linger in the near term, we see today’s elevated Treasury yields as an especially compelling opportunity in fixed income.

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Muni yields are attractive

The war in Iran has increased volatility across fixed income markets, pushing municipal bond yields higher as investors reassess inflation risk, energy costs and the path of Federal Reserve policy. Even so, historically elevated municipal bond yields present a compelling opportunity for tax-sensitive investors.