By Paul R. La Monica

Small-cap stocks are off to a hot start in 2026 and they're beating their larger counterparts so far this year. The Russell 2000 index is up more than 6% already this month, outperforming the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite indexes to kick off 2026. One possible reason? Chalk it up to the January effect, the tendency of small-cap stocks to pop in the first month of the year.

Small stocks often do well to start the year before giving up some gains to better-known indexes. Some market experts suggest that it's a case of investors looking for lesser-known bargains at the beginning of the year, companies that may have been left behind in the previous 12 months.

But this rally could go on longer. The Russell 2000 and the S&P Small Cap 600 indexes have both underperformed the large-cap indexes for several years. The hope is that this trend could reverse itself in 2026 thanks to lower interest rates -- since small companies often have more floating-rate debt than big companies -- and a resilient U.S. economy.

Favorable valuations might help, too. Smaller companies tend to trade at discounts to blue chip stocks, but the gap is now wider than usual. The S&P Small Cap 600 currently trades at around 15.6 times earnings estimates for 2026, according to FactSet. That's 31% lower than the S&P 500's price-to-earnings ratio of 22.6. The S&P Small Cap 600 has tended to trade at just a 25% discount to the S&P 500 over the past five years, though, so there is room for upside if that valuation gap narrows.

"It's now more interesting to look at smaller companies that have been left behind," said Samuel Rines, macro strategist with WisdomTree.

That's especially true when you consider that profits for smaller companies are expected to grow at a slightly faster clip than earnings for the S&P 500.

According to data from FactSet, earnings per share for the S&P Small Cap 600 are forecast to rise 15.4% in 2026 compared to 14.8% growth for the S&P 500. So it's no longer the case that investors have to flock to the S&P 500 and the megacap technology stocks of the Magnificent Seven to find better earnings.

"Don't fight the trend. We're starting to see a broadening out of this rally and small caps are participating," said Sean Clark, chief investment officer with Clark Capital. Clark told Barron's that his firm has been adding small-caps, particularly value stocks, to some of his portfolios.

Others think small-caps in sectors outside of tech could perform well this year, too. Peter Roy, a portfolio manager with Argent Capital, told Barron's that he likes industrial stocks, such as aerospace and defense equipment maker RBC Bearings, as well as healthcare stocks, most notably Ensign Group, which operates skilled nursing and senior living centers. Roy owns both stocks in the Argent Focused Small Cap exchange-traded fund.

Roy also said that he wouldn't be surprised to see more takeover activity in the market this year, thanks to low interest rates and a favorable regulatory environment. That could give small stocks a lift.

"Mergers and acquisitions could be a natural tailwind for small-caps," he said, noting in particular that small garbage-collection and landfill firm Casella Waste Systems could be a target for larger rivals such as Waste Management, Republic Services, or Waste Connections.

Roy also thinks that smaller banks could get scooped up, adding that regional lender Glacier Bancorp in Montana might be a potential acquisition.

But even if there isn't an uptick in merger activity, small-caps still might benefit from the combination of a favorable rate environment and relatively stable economy in the U.S. It might finally be time for investors to play small ball again after years of focusing almost exclusively on the market's giants. This may not be a one-and-done rally for small-caps that lasts only through January.

Write to Paul R. La Monica at paul.lamonica@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.

(END) Dow Jones Newswires

January 12, 2026 15:16 ET (20:16 GMT)

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