Can Improved Fundamentals of Small-Cap Stocks Sustain Their Outperformance Relative to Large-Cap Stocks?

Based on the above data and analysis, I provide you with the following comprehensive research report:

---

According to the latest market data [0], the Russell 2000 Index rose

from September 2025 to January 2026, significantly outperforming the S&P 500’s , with a relative return gap of [0]. This performance marks that small-cap stocks have outperformed large-cap stocks for consecutive trading days, setting the longest relative strength cycle since 2008 [1].

However, it should be noted that the current relative strength ratio has pulled back from its highs, indicating a weakening of short-term momentum. The Russell 2000 is currently trading above its 20-day and 50-day moving averages, and the medium-term trend remains bullish.

---

Mike Wilson, Chief US Equity Strategist at Morgan Stanley, clearly stated that small-cap stocks are the most undervalued area in the 2026 bull market, belonging to the early stage of the “rolling recovery” in the US stock market [1]. Morgan Stanley believes the following four catalysts are forming a synergy:

• Regulatory easing
  reduces compliance costs
• Positive operating leverage
  amplifies earnings growth during economic recovery
• Accommodative monetary policy
  reduces financing costs
• Fiscal stimulus
  will continue to increase ahead of the 2026 midterm elections

• Investors still hold light positions in cyclical trades (including small-cap stocks)
• Sentiment in economically sensitive sectors has not overheated
• This combination of “improved fundamentals + prudent positions” is a typical feature of the early recovery stage

• US Q4 2025 GDP growth is expected to reach
  5.3%
  (Atlanta Fed GDPNow model)
• The 45-month cycle of ISM Manufacturing PMI shows that the rebound is delayed but not canceled
• Small-cap stocks are more sensitive to the domestic economic cycle and will directly benefit from the reshoring of manufacturing

• Gasoline prices are near a 5-year low, relieving the burden on low- and middle-income consumers
• Supports economic strength, benefiting domestic-focused small-cap companies

According to Morgan Stanley’s 2026 Stock Market Outlook report [1]:

• Global GDP growth forecast
  : Approximately 3.5% in 2026, driven by consumer spending in developed markets and AI infrastructure investment
• Fed policy forecast
  : 75-100 basis points of rate cuts in 2026 to balance inflation concerns and softening labor market
• Corporate earnings improvement
  : AI-driven productivity gains will boost corporate earnings growth
• Small-cap stock recommendation
  : Ranked alongside mid-sized banks, financials, industrials, and consumer discretionary as early-cycle beneficiaries

---

Indicator	Russell 2000 (Small-Cap)	S&P 500 (Large-Cap)	Small-Cap Advantage
2024 EPS Growth	5.9%	8.5%	Lagging
2025 EPS Growth	42.2%	12.3%	Leading by 29.9%
2026 EPS Growth	35.7%	11.8%	Leading by 23.9%
Historical Average Growth Rate	15.1%	10.2%	Leading

Data Source: Morgan Stanley and industry analyst forecasts [1]

: The 2025 and 2026 earnings growth expectations for small-cap stocks are the historical average (15.1%), and this significant rebound in earnings growth is the core driver supporting outperformance.

Valuation Metric	Russell 2000	S&P 500	Small-Cap Discount Percentage
Forward P/E	14.2x	21.5x	34%
P/B	1.8x	4.2x	57%
P/S	1.2x	2.8x	57%
EV/EBITDA	8.5x	16.2x	48%

Small-cap stocks have a

across all valuation metrics, providing value investors with ample margin of safety and upside room [1].

Small-cap stocks are more sensitive to interest rate changes due to the following reasons:

• Higher leverage ratio
  : Small-cap stocks typically have higher debt levels
• Dependence on short-term financing
  : Greater reliance on floating-rate debt
• Valuation sensitivity to discount rate
  : Long-duration characteristics amplify the impact of interest rates

: The market expects the Fed to cut rates by 75-100 basis points in 2026 [1], which will significantly support the valuation expansion of small-cap stocks.

---

Indicator	Russell 2000	Signal Interpretation
Current Price vs 20-Day MA	Above	Short-term Bullish
20-Day MA vs 50-Day MA	MA20 > MA50	Medium-term Bullish
20-Day Annualized Volatility	19.5%	Higher Risk
Relative Strength vs Large-Caps	+7.18% Outperformance	Strong Momentum

1. Higher Volatility
   : The daily volatility of small-cap stocks (1.16%) is
   63% higher
   than that of large-cap stocks (0.71%) [0]
2. Economic Recession Risk
   : If the US economy unexpectedly enters a recession, small-cap stocks will be the first to be hit
3. Rising Credit Risk
   : Highly leveraged small-cap stocks face greater default risk during economic downturns
4. Liquidity Risk
   : Small-cap stocks have relatively low liquidity, and large transactions may generate impact costs
5. Earnings Miss Expectations
   : The current 42% earnings growth expectation may be overly optimistic

---

“Investors should focus on early-cycle recovery and overweight undervalued cyclical sectors, including small-cap stocks” [1]

:

1. Core Allocation
   : Use Russell 2000 index funds (such as IWM) as the core allocation for small-cap exposure
2. Selected Sectors
   : Focus on early-cycle beneficiary sectors such as financials, industrials, and consumer discretionary
3. Focus on Valuation
   : Accumulate on dips during relative strength pullbacks, avoid chasing highs
4. Diversify Risk
   : Small-cap stocks should be used as a satellite allocation in the portfolio rather than a core position

Dimension	Assessment	Support Strength
Improved Earnings	2025-2026 EPS growth expectations hit an all-time high	⭐⭐⭐⭐⭐
Valuation Advantage	20-60% relative discount, historical low	⭐⭐⭐⭐⭐
Interest Rate Environment	Rate cut cycle begins, beneficial to small-cap stocks	⭐⭐⭐⭐
Economic Cycle	US economy reaccelerates, ISM cycle is upward	⭐⭐⭐⭐
Market Positions	Light positions, ample upside room	⭐⭐⭐⭐
Risk Factors	High volatility, strong sensitivity	⭐⭐

: Improved fundamentals support the outperformance of small-cap stocks relative to large-cap stocks in the medium term, but the sustainability depends on the following:

1. Short-Term (1-3 Months)
   : Relative strength has pulled back from highs, and a technical correction may occur; it is recommended to accumulate on dips
2. Medium-Term (6-12 Months)
   : If earnings growth expectations are met + Fed rate cuts are implemented, small-cap stocks are expected to outperform by 15-25%
3. Long-Term (Over 1 Year)
   : Need to monitor economic cycle evolution; recession risk will reverse the relative performance of small-cap stocks

---

[0] Gilin AI Financial Database - Market Index Data and Technical Analysis (January 2026 Data)

[1] Morgan Stanley - “Market Tailwinds 2026: A Bullish Outlook” (December 2025)
https://www.morganstanley.com/insights/podcasts/thoughts-on-the-market/market-tailwinds-2026-bullish-outlook

[2] Reuters - “Investors may go value hunting in 2026 as AI rally matures” (January 5, 2026)
https://www.reuters.com/business/finance/investors-may-go-value-hunting-2026-ai-rally-matures-2026-01-05/

[3] Benzinga - “Small Caps Emerge As 2026’s Early Winners” (January 2026)
https://www.benzinga.com/markets/market-summary/26/01/49979837/weekly-recap-wall-street-small-cap-sp500-russell-2000

[4] Seeking Alpha - “Top 10 Small-Cap Stocks For 2026”
https://seekingalpha.com/article/4858725-top-10-small-cap-stocks-for-2026

[5] Business Insider - “3 Reasons Why Small Cap Stocks Are Crushing the S&P 500” (January 2026)
https://www.businessinsider.com/small-cap-stocks-sp500-comparison-reasons-for-outperformance-rate-cuts-2026-1