MW U.S. small-cap stocks have been playing catch-up for years. Don't expect that to change anytime soon, analyst warns

By Joseph Adinolfi

Small caps will likely continue to lag their large-cap peers in the U.S., even if worries about the economy ease

For much of the past decade, U.S. small-cap stocks have lagged behind their large-cap peers.

To be sure, this trend has been punctuated by brief bouts of outperformance, like the "great rotation" trade that took investors by surprise last summer.

But anybody hoping for a more sustainable reversal might want to temper those expectations. According to John Higgins, chief markets economist at Capital Economics, large caps will likely continue to provide superior returns for the foreseeable future, even if investors' worries about the state of the U.S. economy start to fade.

"[U.S. small-cap] equities could conceivably be in for an easier time if worries about the U.S. economy ease. That is something we envisage, despite potential flashpoints in the trade war in the coming months. It may not be enough, however, to trigger a lasting turnaround in their relative performance," Higgins said in a report shared with MarketWatch.

Small-cap bulls frequently cite cheap relative valuations as a good reason to stay invested. But as Higgins pointed out, attractive valuations have rarely proved useful when trying to time the market. And regardless, investors aren't in the mood for bargain hunting.

Instead, Higgins expects they will continue to pay a premium for stocks associated with artificial intelligence. Right now, many of the AI leaders are megacap stocks like Nvidia Corp. $(NVDA)$

Higgins also addressed the notion that robust gains tallied by Nvidia and other Big Tech stocks have somehow skewed the relative performance. As it turns out, small-caps have underperformed large-caps on an equal-weighted basis as well.

Interestingly, the weak relative performance for small-caps appears to be a U.S.-focused phenomenon. As Higgins showed, small-caps in Europe have done a much better job of keeping pace with their large-cap peers this year.

Although U.S.-based small-cap indexes like the Russell 2000 and S&P 600 SML have recovered from April's tariff-induced turmoil, they have remained solidly in the red year-to-date. As of midday on Tuesday, the Russell 2000 RUT was down by nearly 6% in 2025. The S&P 600 is off by nearly 8%. The S&P 500 SPX, by comparison, was trading up more than 1.5% on the year, according to FactSet data.

Decades ago, research conducted by Nobel laureates Eugene Fama and Kenneth French posited that small-cap stocks should deliver a premium for investors over the long term, due to the higher risk of investing in smaller, unproven firms. Other researchers have found that small-caps can generate excess returns over longer time horizons as well.

-Joseph Adinolfi

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June 03, 2025 13:42 ET (17:42 GMT)

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