Recent data released by US banks shows that earnings growth for the S&P 600 small-cap stocks has turned positive, with an expected growth rate of 18-19% by 2026, surpassing the 13% for large-cap stocks and 15-16% for mid-cap stocks. It's quite encouraging—after all, small-cap stocks experienced earnings contraction for several quarters in 2022-2023. Now, benefiting from the rate cut cycle, lower financing costs, and a rebound in capital expenditure, they are finally seeing a turnaround.

From a valuation perspective, they are indeed cheap. Currently, small-cap stocks have a P/E ratio of 15.6, which is 31% cheaper than the market average, a discount that even exceeds the historical average. In 2025, institutional funds still net flowed into small caps by $6.4 billion, while a net outflow of $45 billion went from large caps. This appears to be a signal of a major trend shift.

But there are issues that become apparent upon closer inspection.

First, that 18-19% growth rate is essentially a base effect. The extent of earnings decline in small caps over the past two years was significant, so the low base makes the rebound look impressive on paper. However, whether the actual recovery is sustainable remains uncertain. Second, market sentiment has already reached an extremely bullish level. The rotation of funds from large caps to small caps typically occurs in the late stage of a bull market or the early stage of a bear market—this timing itself warrants caution. Third, more practically, small caps are more sensitive to economic downturns and tend to have higher leverage. If a hard landing occurs in 2026 or if rate cuts stop, their decline could be sharper than that of large caps.

Honestly, this narrative on Wall Street has been around since 2022. Back then, the story was that small caps would soon outperform, mainly because of cheap valuations, imminent rate cuts, and economic recovery. But what happened? In 2022-2023, small caps kept plunging, while in 2024, large caps—especially those related to AI—continued to surge, with small caps still lagging behind. The real performance only started around late 2025 to early 2026. During these three years, investors who stuck with small caps not only failed to make money but also missed out on the multi-bagger runs of leading companies.

Rather than calling this a bullish recommendation, it’s more like a hedging strategy—when large caps surge too aggressively and institutions need to tell clients a new story, they bring out the "value gap" of small caps. In the short term, small caps do have some relative advantages, but the overall market risk is actually accumulating.