Small caps rally 18% year to date as economy fuels rotation

The Russell 2000 has surged 18% this year, outpacing the S&P 500 by the widest margin since 2021 as investors rotate from mega-cap tech into smaller companies.

The Russell 2000 has surged 18% this year, outpacing the S&P 500 by the widest margin since 2021 as investors rotate from mega-cap tech into smaller companies.

"The economy has proven more resilient than many expected, and that's been a tailwind for the types of domestic-focused companies that populate the Russell," said Chris Retzler, portfolio manager of the Needham Small Cap Growth Fund, on CNBC's "Squawk Box." "We're seeing broadening participation beyond the Magnificent Seven."

All three major US indexes closed at records Wednesday, with the Dow Jones Industrial Average rising 0.4%, the S&P 500 adding less than 0.1% and the Nasdaq Composite gaining 0.1%. Travel stocks led the advance as oil prices tumbled on optimism about a US-Iran peace deal, with Brent crude settling down 5.3% at $94.29 a barrel. Norwegian Cruise Line Holdings gained 6.5%, United Airlines rose 7% and Delta Air Lines added 5%. The 10-year Treasury yield slipped to 4.48%.

The rotation into small caps signals that investors are betting on sustained domestic growth and a stabilizing rate environment, rather than concentrating capital in the mega-cap technology stocks that dominated for two years. The dollar index edged higher to 99.19, while gold futures declined 1.1% to $4,455 an ounce. The May jobs report, due June 5, will shape expectations for the Federal Reserve's rate path and test the rally's durability.

The breadth of the rally has been notable. Four stocks in the Russell 2000 have gained more than 400% this year, led by semiconductor company MaxLinear. The advance-decline ratio has consistently favored gainers, a contrast with the narrow leadership that characterized the 2024-2025 bull market.

The shift has been accompanied by a rotation out of the largest technology names. The iShares Semiconductor ETF slipped more than 1% Wednesday, with Qualcomm falling more than 6% and Marvell Technology declining 4.6% ahead of its quarterly results. Meta Platforms rose nearly 4% after saying it would begin selling subscriptions to enhanced versions of its social-media products.

Why Small Caps Are Catching Up

The outperformance reflects a confluence of factors. The US economy has added jobs at a solid pace through early 2026, consumer spending has held up and corporate earnings have broadened beyond technology. Small-cap companies, which tend to have more domestic revenue exposure and higher sensitivity to economic cycles, have benefited disproportionately.

"The AI trade is still real, but it's no longer the only game in town," Retzler said. "We're seeing earnings momentum spread to industrials, financials and consumer cyclicals — areas where small caps have more representation."

Oppenheimer Chief Investment Strategist John Stoltzfus said the broadening of the market is a healthy development. "The rally is becoming more inclusive, and that's typically a sign of durability rather than excess," he said.

The sustainability of the rotation hinges on the trajectory of interest rates. Smaller companies carry more floating-rate debt than their large-cap peers, meaning a rate cut would provide a disproportionate earnings boost. A reacceleration of inflation or a hawkish surprise from the Fed would hit the Russell 2000 hardest.

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