Sheryar Siddiq
10 min read
Small-cap stocks have entered a more selective phase following a strong first-half surge that collided with increasing borrowing costs and renewed investor preference for AI-linked megacaps. The Russell 2000 rose about 22% in the first half of 2026, its best start since 1991, before entering correction territory in mid-October, closing 11% lower than its August 14 record close. The pullback was obvious across the market, with Insider Monkey’s coverage of the biggest gainers and losers on October 15 showing the abrupt shift away from riskier sections of the market. The slide hasn’t erased the year’s gains, but it has pushed investors to decide between companies with long-term earnings strength and those that are simply riding the broader small-cap rally.
The fundamental backdrop remains more supportive than recent price action might suggest. Russell 2000 earnings per share increased roughly 43% in the second quarter, well ahead of projections near 26%, while roughly two-thirds of companies exceeded both revenue and earnings estimates. Janus Henderson forecasts small-cap earnings to climb 21.8% in 2027, outpacing its 10.6% estimate for large caps, while adding that the Russell 2000’s relative forward valuation remains historically attractive even after the gap with large caps narrowed.
This combination of robust earnings growth and a still-attractive relative valuation is driving investors back to smaller companies. However, increased long-term Treasury yields remain the key concern. Small caps tend to have more floating-rate or shorter-duration debt than mega-caps, and their valuations are more heavily based on earnings expected further in the future. When the 10-year Treasury yield rises, that future cash flow is discounted more heavily, reducing multiples even when operating results improve.
Royce Investment Partners said the third quarter was a temporary setback after a stellar run, though adding that the climate remains favorable for high-quality small- and micro-cap companies with strong fundamentals. The firm’s Q3 2026 Small Cap Fund letter noted that both the Russell 2000 and Russell Microcap indexes declined 7.2% during the quarter, showing how quickly opinion can shift even while company-level value stays intact.
Longleaf Partners took a similar stance in its Q3 2026 Small-Cap Fund letter, highlighting that concentrated portfolios and company-specific catalysts are more important than broad index exposure in a market where valuations and sentiment can fluctuate sharply.
