US small-cap stocks have outpaced large caps in 2026. Will their strong earnings growth, market breadth, and discounted valuations support further upside?

US small outperformed US large caps in the first half of 2026, returning 22.93%—‬their best first-half ever—to outpace large caps’ 9.55% gain.¹ The resulting 13.38% excess return also marked small caps’ strongest relative first-half performance on record.²

Yet many investors appear to have missed the move. Inflows into US small-cap ETFs totaled just $7 billion in the first half of 2026, compared with $309 billion for US large-cap ETFs. That disconnect suggests that the rally—supported by improving market breadth and rising earnings estimates—may be more durable than many investors realize.

These three charts help explain why.

A rally built on broad participation

The headline return was impressive. But the breadth behind it was even more notable.

The strong return was not driven by one segment or style. Every sector in the S&P 600 Small Cap Index posted a positive first-half return, and both traditional small-cap growth and value style box exposures were positive as well.³

The breadth of small-cap strength becomes even more impressive when viewed relative to large caps. All eleven small-cap sectors outperformed their large-cap counterparts—a feat that has never occurred in a calendar year across more than 30 years of available index data.⁴

The average small-cap sector return—an equal-weighted sector proxy —was 23% in the first half, compared with 9.2% for the average large-cap sector.⁵ That 13.6% excess return ranks as the second-highest on record, behind only full-year 2016 performance (Figure 1).

Back then, small caps were supported by expectations for post-election pro-business legislation, including tax cuts that were later enacted. Similarly, small caps today are benefiting from stimulative measures in the One Big Beautiful Bill Act. Adjusting for 2016's post-election surge, the 13.6% average small-cap sector excess return over large caps represents the strongest first-half relative performance on record.⁶

The same strong relative performance was evident across style trends. Despite the significant attention paid to mega-cap growth, small-cap growth and value barometers have outperformed their large-cap peers by 13% and 15% so far this year.⁷ The last time both small-cap style exposures posted double-digit excess returns at the same time was 2002.⁸

Earnings trends support the momentum

The strength in performance has been supported by rising fundamental momentum. 2026 earnings growth expectations were revised upward from 15% at the end of Q1 to 20% at the end of Q2.⁹ Full-year upside revisions were supported by stronger Q3 and Q4 estimates, suggesting the improvement not from just one strong quarter (Figure 2).

The upward revision is not limited to a handful of companies. The upgrade-to-downgrade ratio improved to 1.5 from 1.0 at the end of March.¹⁰ At the sector level, seven sectors now have upgrade-to-downgrade ratios above 1,¹¹ suggesting earnings upgrades are becoming more broadly distributed across the market.

This earnings growth impulse has been supported by the shifting macro backdrop and AI-driven capital expenditure boom. At the same time, healthy labor markets and expanding manufacturing activity continue to support the US economy. The ISM Manufacturing PMI has remained above 50—signaling expansion—throughout every month of 2026. The last time the index sustained six consecutive months above 50 was during the post-COVID recovery in 2021–2022.¹²

Against this backdrop, small-cap companies are particularly well positioned. Given their predominantly domestic revenue exposure, small-cap companies are positioned to benefit from accelerating capital spending, infrastructure investment, and renewed investment in US manufacturing and supply chains.

These trends may prove more durable than prior cyclical tailwinds, reflecting a new macro reality characterized by deglobalization, reshoring, and rising domestic investment.

Fundamentals—not short covering—driving returns

The strong index performance and fundamental momentum have coincided with broader single-stock participation, signaling greater depth and durability in the rally.

At the end of the first half, the share of small-cap stocks outperforming the broader Russell 2000 Index stood in the 97^th percentile over the past 20 years.¹³ The recent average has also been trending higher alongside the strengthening earnings picture—a constructive sign for a sustainable rally.

Further supporting the case for rally sustainability, gains do not appear to be driven by short covering. In prior small-cap rallies, short covering was often evident. Today, however, when the small-cap universe is segmented by shares sold short, stocks with higher short interest are not rallying more strongly than those with lower short interest.

Figure 3 illustrates the average first-half 2026 return for small-cap stocks grouped by short-interest decile. The decile with the highest short interest has produced the weakest return so far this year, while the bottom five deciles—those with lower short interest—have posted a stronger average return (+25%) than the highest five short interest deciles (+23%) as well as the average stock return (+24%). That suggests the rally has not been driven by non-fundamental factors.

Broader participation across sectors, styles, single stocks, and earnings—supported by economic growth impulses—reflects a durable foundation for small caps. Yet valuations remain supportive. A blended ensemble valuation screen indicates small caps are trading at a 45% discount to large caps, compared with a typical 18% discount over the past 20 years.¹⁴

The main risk: Higher interest rates

A shift in US monetary policy poses one potential headwind to the seemingly durable small-cap rally. If the Federal Reserve raises rates later this year as markets expect, higher borrowing costs could challenge both price and fundamental momentum.

Small caps are more indebted than large caps and, therefore, more sensitive to changes in interest rates. This greater reliance on debt financing is reflected in small caps’ higher net-debt-to-EBITDA ratios versus large caps.¹⁵

Regression analysis also shows slightly higher beta sensitivity to changes in the US 2-year and 10-year Treasury yields than large caps—0.05 and 0.11 versus 0.03 and 0.05, respectively—over the past 20 years.¹⁶

Although higher rates bear watching, the evidence suggests the risk may be manageable. Small-cap net-debt-to-EBITDA ratios have declined over the past one, two, and three years and also sit below their recent 10-year average.¹⁷

Big picture? The charts and data show how the breadth of participation, improving fundamentals, supportive valuations, and still-muted investor positioning suggest the small-cap story may be far from over.

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