MW Why the Russell 2000 has a real chance to beat the S&P 500 - finally

By Matthew F. Shannon

Small-cap stocks look primed for their big moment. But we've been here before.

After eight consecutive years of underperformance by small-cap stocks relative to large caps, many investors are questioning when or even if this investment paradigm will shift. This environment is similar to the 1990s, which culminated in the tech bubble and a subsequent shift in investor preferences toward small-cap stocks.

This divergence in performance between the two asset classes has created a significant gap between them in terms of valuation. The Russell 2000 RUT, a standard benchmark for small-cap securities, has been trading at its most inexpensive valuation since 2008 compared with the S&P 500 SPX - over one standard deviation cheaper. Given this disconnect, one could easily make the case for a mean reversion trade between small and large caps. But that could have been said any time over the past three years, and nothing has materialized.

In this market, valuation is a condition and not a catalyst. What could happen to cause investors to change their preferences and start to buy undervalued small-cap stocks?

The perception that the Russell 2000 is a low-quality index could change due to stronger fundamentals and greater U.S. economic certainty. One reason investors are hesitant to allocate toward small caps is the historically elevated percentage of negative-earning companies in the Russell 2000, on par with levels seen during the tech bubble and the global financial crisis. After falling from its peak level during the COVID-19 pandemic, the percentage of negative-earning companies has once again begun to climb.

Given this recent change, it is worth considering the underlying cause and whether it could reverse. Currently, there are roughly 4,300 public companies, whereas in 2000, there were about 7,000. Historically, private companies would pursue initial public offerings to gain greater access to the capital markets and fund their growth. This shifted in the wake of the financial crisis, with the Federal Reserve pursuing a zero-interest-rate policy that allowed companies to stay private longer, as they were able to meet their capital needs in the private markets. These private-equity investors tend to prefer high-quality firms over more speculative ventures.

By this logic, the continued high percentage of negative earners in the Russell 2000 is due to a subdued IPO market and to small profitable businesses remaining private. This dynamic is showing signs of changing, as interest rates are no longer at zero and private capital is less abundant. There have been 95 IPOs so far in 2025 (excluding blank-check companies), raising $12.9 billion, compared with a total of 73 deals that raised $16 billion in 2024. Should this trend continue, it could boost the quality of publicly traded small-cap companies and make the asset class more appealing to investors.

Additionally, for the past two years, we have not been in a clear market regime (recovery, midcycle, late cycle, recession), and that has prevented investors from gaining a more long-term view of their investment decisions. Entering a new market regime instead of vacillating between recession and recovery would also be beneficial for the small-cap asset class.

In this environment, the market has further narrowed, with winners being an extremely narrow subset of investments that are speculative and narrative-driven, such as meme stocks and artificial-intelligence and quantum-computing names. Small-cap names have been overlooked because they did not constitute a large portion of the asset class, and the hyper-short-term focus of the market did not allow investors to look beyond the here and now.

Improving fundamentals

As the market progresses away from tariffs and macroeconomic volatility, investors should be able to look at companies' underlying fundamentals. We have begun to see improvement in small-cap earnings versus their large-cap counterparts, reversing a trend not seen since 2022.

This setup is compelling for the small-cap asset class, but investors could continue to allocate their risk budget elsewhere. So long as there is no diminishing return on AI investments and investors believe that nothing besides the big names is worth investing in, large-cap tech companies could continue to post positive earnings surprises. This would lead investors to maintain their current risk budgets and allocations, resulting in no capital entering the small-cap space and a continued preference for the narrow leadership that has worked recently.

We think that this lopsided positioning will eventually swing, but time will tell. If these market and fundamental changes occur, this should be a strong backdrop for small caps, though certain areas will likely benefit more than others.

Currently, we are finding opportunities in the more cyclical areas of the market, such as financials, industrials and materials. In these sectors, a number of companies trade at valuation discounts despite generating significant free cash flow. Investors have abandoned these shares as the near-term revenue growth opportunity is unclear in this environment, but there is a path to longer-term growth from current levels.

Conversely, the healthcare and consumer discretionary sectors are less attractive due to shifts in the operating environment that have added more hurdles to long-term investment success. Investors have been quick to extrapolate any element of unwelcome news into the future and sell shares indiscriminately. While a business model may see success at some point, the downside risks associated with owning companies that are more binary in nature in the short term are higher than we are comfortable with.

Overall, the conditions are present for a possible paradigm shift in small caps. The first indicator of such a shift will be the market reaction to improving balance sheets and whether investors then start to focus on fundamentals as a result.

Matthew F. Shannon is a portfolio manager for GlenmedeInvestment Management LP. His primary responsibility ismanaging the Small Cap, SMID Cap and Mid Cap Equity strategies.

More: History says the latest small-cap rally could spell trouble for the S&P 500: BTIG

Also read: Why a 'wall of money' is unlikely to flood into stocks when the Fed cuts rates

-Matthew F. Shannon

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August 19, 2025 13:35 ET (17:35 GMT)

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