Small caps are poised to finish 2025 with a fifth consecutive year of trailing large caps, yet Bank of America says conditions are aligning for a long-awaited reversal in 2026.
According to Bank of America, the long-neglected small-cap stocks are set up to be the market’s surprise winners in 2026, supported by Fed cuts, M&A momentum, and a U.S. capex revival as key catalysts.
Bank of America Predicts Small-Cap Stocks Will Beat S&P 500 in 2026
In a note shared Tuesday, Bank of America strategist Jill Carey Hall declared a bullish stance on the Russell 2000 – as tracked by the iShares Russell 2000 ETF (NYSE:IWM) – saying she expects small caps to “outperform mid and large caps” as economic conditions and market flows turn in their favor.
"We are bullish on small caps in 2026, expecting small caps to outperform mid and large caps," Hall says.
The call rests on five key reasons that could unleash a multi-year rally for the Russell 2000 index.
1) Earnings Momentum Is Shifting
Earnings momentum is poised to be a key driver of small-cap outperformance in 2026, with consensus forecasts pointing to stronger and accelerating profit growth for smaller companies.
Analysts expect S&P SmallCap 600 earnings to rise 19% in 2026, well above the 13% gain forecast for the S&P 500 and 15% for the S&P MidCap 400.
Historically, small caps have outperformed large caps by an average of 9 percentage points in similar environments, particularly when profit growth is both stronger and accelerating.
2) CAPEX Cycle To Raise Small-Cap Revenue
BofA expects a powerful U.S. capital spending cycle tied to infrastructure upgrades, hyperscale data center buildouts, reshoring and automation.
"Our work suggests that small-cap sales growth is more highly correlated to capex than large caps," said Hall.
Bank of America data shows that small-cap revenue growth has historically trended upward in periods where corporate spending rose, indicating a powerful tailwind is forming.
3) Fed Rate Cuts To Ease Financing Pressures
Smaller firms are more rate-sensitive and often carry more floating-rate or short-term debt.
With consensus calling for three rate cuts in 2026, Bank of America sees relief on the horizon.
Hall estimates the cumulative hit to Russell 2000 non-financial operating earnings from higher rates could reach 32% over five years—but each additional 25 basis point cut would reduce the hit by roughly 2 percentage points.
Historically, small caps tend to outperform in the year following the first Fed rate cut, especially during cycles tied to recessions. In about 60% of those recession-linked easing cycles, small caps beat large caps.
4) Lower Tariffs And Deregulation To Boost Margins
According to a 2023 National Association of Manufacturers study cited by Hall, regulatory burdens fall hardest on the smallest firms.
Companies with fewer than 50 employees face annual compliance costs of $14,700 per worker, 20 percent higher than firms with more than 100 employees.
Even though fewer than 15 percent of Russell 2000 constituents fit that size definition, the skew suggests the group could see stronger margin relief from potential policy changes.
Furthermore, tariff uncertainty crushed small caps in early 2025, but relief from exemptions or legal challenges could strongly boost small-cap margins next year.
5) Favorable Positioning And Compelling Valuation
Small caps have been completely neglected, but that’s changing fast. Multi-cap fund managers are currently 60% underweight the size segment. This is the lowest weight since the Global Financial Crisis.
Yet, flows are already turning. Bank of America client flow data shows clients are finally buying small-cap single stocks this year and hedge fund inflows have picked up in recent months.
The retail crowd is also a swing factor. Retail investor participation in small caps has surged since 2023, averaging 35% to 40% of volume. Small caps have historically outperformed large caps in periods of high retail trading.
Last but not least, valuations remain appealing at least on a relative basis.
The Russell 2000 forward price-to-earnings ratio of 16 is only slightly above its long-term average. But more importantly, relative to large caps, small caps are cheap: the forward P/E of 0.72 is well below the historical norm of 0.99.
BofA’s regression models suggest that over the next decade, small caps could deliver annualized returns of 9%, far above the 1% expected from large caps.
“Our work suggests that valuation tends to be a poor short-term timing indicator, but it matters much more for long-term (10-year) returns,” Bank of America wrote.
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