Small-cap stocks surge 22% as AI trade broadens beyond megacaps

The Russell 2000 surged 22% in the first half, its best since 1991 and more than double the S&P 500's 9.5% gain.

"It's both a valuation catch-up story and a fundamental story," said Amy Zhang, portfolio manager at Alger. "The valuation gap was so wide that a truck can drive through it."

Semiconductor and semiconductor-equipment companies led the advance, accounting for 16 of the Russell 2000's 50 best-performing stocks. Aehr Test Systems, Ichor Holdings and MaxLinear each rallied more than 400%. The S&P Small Cap 600 rose 23% in the period, outpacing the Dow's 8.9% gain and the Nasdaq Composite's 12.8% advance. The S&P Small Cap 600 trades at 17 times forward earnings, a 22% discount to the S&P 500's 22 times — wider than the 10-year average discount of 12%.

The rotation into small caps reflects growing conviction that profit growth is broadening beyond megacap technology names. Analysts forecast a 12% increase in S&P Small Cap 600 earnings this year and 18% growth in 2027. The biggest risk: higher interest rates. The Federal Reserve next meets July 28-29, with traders pricing in about a 30% chance of a rate increase, according to CME Group's FedWatch tool. Bank of America estimates every additional 25-basis-point hike would reduce Russell 2000 operating earnings by about 2%.

AI Supply Chain Powers the Rally

The small-cap surge has been powered by the same force driving large-cap markets: artificial intelligence infrastructure spending. As cloud providers and chipmakers increase capital expenditure, suppliers of semiconductor equipment, components and connectivity solutions are capturing a growing share of that investment. Unlike the megacap AI leaders such as Nvidia, these smaller companies benefit from a lower revenue base, increasing the impact of incremental spending on their earnings growth.

"The effect will be more pronounced for small-cap companies, in terms of revenue and probability growth," Zhang said.

Earnings Momentum Broadens Beyond Tech

Beyond AI, strategists point to a broader set of tailwinds. Consensus forecasts for Russell 2000 companies' 2026 earnings growth have climbed to 38% from about 23% at the start of the year, according to LPL Financial. Adam Turnquist, chief technical strategist at LPL, cited additional catalysts including expectations for increased merger activity, particularly in pharmaceuticals and biotechnology, and tax incentives designed to encourage capital investment.

"Small-cap leadership has been notable during the mega-cap-driven bull market, although small caps have meaningful exposure to semiconductors and technology hardware," Turnquist said.

Higher borrowing costs pose a particular challenge for smaller companies, which carry more floating-rate debt and face greater refinancing needs than their large-cap peers. The Fed raised rates by 500 basis points between March 2022 and mid-2023, and markets now see more than a 60% probability of at least one quarter-point hike by September. Even so, many investors believe the worst of the tightening cycle is past. "We're probably close to peak inflation and peak rates," Zhang said.

Several actively managed small-cap ETFs have outperformed this year. The abrdn Focused U.S. Small Cap Active ETF, Fidelity Enhanced Small Cap Core ETF, Goldman Sachs Small Cap Equity ETF and Avantis U.S. Small Cap Equity ETF are all up more than 25% in 2026, according to ETF Database. Trivariate Research analysts cautioned that adding to small caps at current levels represents increased risk, suggesting that investors seeking exposure may prefer small-cap value strategies.

This article is for informational purposes only and does not constitute investment advice.