By Jacob Sonenshine

Small-caps are crushing it. And plenty of things can push the stocks even higher.

The S&P 600, a benchmark index for small-caps, is up 10% after jitters about Fed cuts and AI dragged down much of the market a few weeks ago. For comparison, the S&P 500 is up 3.5% since that blip.

Uncertainty about the economy has certainly eased so small-cap investors are naturally feeling less anxious.

A weakening labor market and a slowdown in inflation give the green light for more rate cuts. Plus, the Federal Reserve plans to buy hundreds of billions of short-term Treasury bonds annually, another move that would pump money into the financial system and hold down rates.

The point: more economic growth over the next year or two, even if mild.

This all benefits small-caps primarily because faster economic growth means more sales and bigger profits -- and many of the S&P 600 companies are in economically sensitive sectors.

The index's heaviest weighted sector is financials. When the outlook for the economy perks up, banks see higher demand for financing and corporate transactions and money managers see higher assets under management because asset prices rise.

Also heavy weights are industrials and consumer discretionary, which benefit from greater business and consumer spending.

But don't forget that lower rates reduce interest expense -- and small-caps have had more floating rate debt than the S&P 500. That means smaller companies have a bigger drop in interest expense, which pumps expectations for profits far higher.

Now, the tough question: Are all of these factors already priced into small-caps?

For the team at 22V Research, the answer -- at least for the immediate future -- is no.

22V's analysts, lead by Dennis DeBusschere, "expect the [small-cap] trend to continue near-term," they write.

DeBusschere emphasizes that small-caps can keep climbing -- as long as the Fed keeps supporting economic growth. The stocks are still fairly cheap. In other words, they haven't necessarily fully reflected the earnings potential.

The S&P 600 trades at just over 15 times aggregate earnings that analysts forecast for the index's companies over the coming 12 months. That's 30% below the S&P 500's just over 22 times, a steeper discount versus the 16.3% average over the past decade, according to our calculations of FactSet data.

The takeaway is that small-cap earnings multiples probably won't drop much here. So if their earnings grow faster than S&P 500 profits, they can outperform.

The ingredients for that winning earnings recipe are two main ones -- a central bank that does what markets expect it to do and smaller companies to match or better current earnings projections.

Right now, FactSet shows that analysts expect almost 4% annual sales growth for the S&P 600 through 2027. That could be enough to lift profit margins.

Wage growth has been similar to that expected sales growth, but with costs such as depreciation not changing much and interest expense probably dropping, net profit margins can rise.

That's why analysts forecast almost 16% annual earnings growth through 2027, compared with the just under 15% for the S&P 500.

The other way small-caps could outperform is if AI stocks have a moment of truth. Wall Street hasn't hidden its worry about Big Tech over-investing in AI.

Let's throw out a couple of examples of how this could play out.

If OpenAI can't pay its chip and software contractors, all AI stocks probably would tank. If Microsoft, Meta Platforms or Alphabet decide to put the brakes on the growth rate of their capital investment, expectations for chip demand would plummet. And that would hit the S&P 500, but not necessarily the S&P 600.

Yes, there are plenty of reasons to bet on the little guys.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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December 18, 2025 12:29 ET (17:29 GMT)

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