Signals & Noise: Why small & mid-caps are leading the 2026 market rally – and what’s next

Hello, and welcome to Signals & Noise, where strategists from around the globe offer a shorter take on market matters as part of Global Research Unlocked. I'm Jill Hall, head of U.S. small and mid-cap strategy at B of A Global Research, and we're recording this episode on Tuesday, June 9th, 2026. Today, I want to focus on the best performing size segment of the U.S. equity market this year, U.S. small and mid-caps, and how we're thinking about them today.

First, let me start with the big picture, why we've been constructive on small and mid-caps, or SMID caps, and why we expect them to outperform mega-caps this year. We expected that 2026 would be a year where earnings, not valuation expansion, drives returns. And small and mid-caps are where the biggest pickup in earnings growth is expected to be, particularly as we get to the second half of this year.

And this segment of the market is less crowded and expensive than mega-caps. One supportive factor for that profits recovery has been the manufacturing recovery. The ISM manufacturing indicator finally improved into expansionary territory this year, and despite the Russell 2000's exposure to non-profitable stocks and its high weight in sectors like biotech, it's actually been more correlated to the ISM indicator in recent years, more so than ever.

And higher oil prices have also been supportive, where the Russell 2000 index has more exposure to sectors that benefit from higher oil than sectors which are hurt by higher oil. And if stagflation risks were to rise, that's typically an environment in which equities have underperformed other asset classes, but within equities, small-caps have historically outperformed large-caps. We also see domestic SMID caps as beneficiaries of reshoring and of a multi-year capital expenditure or capex cycle.

But let's talk about two key topics. Number one, how should investors think about valuations? So the short answer is that U.S. equities broadly trade above historical averages on their price-to-earnings ratios, but SMID caps are the least expensive part of the market.

Both the Russell 2000 small-cap index and the Russell mid-cap index are trading about 17 times forward consensus earnings, while the large-cap Russell 1000 index is trading at 21 times forward earnings. And the relative multiple of small versus large-caps and of mid versus mega-caps is still well below the historic average. So we continue to see relative value in small and mid-caps.

Now, let's talk about one of the key risks to small-caps, the Fed. The Russell 2000 index had become very sensitive to Fed expectations over the last several years, especially beginning in 2022 and the few years after as the Fed raised interest rates and then focus shifted to the start of the new cutting cycle and the reason for the sensitivity is the concern around refinancing risk. So small-caps are more levered and they have more floating rate debt and more short-term debt than large-caps do and they have a higher proportion of their debt coming due over the next five years.

We've estimated that every 25 basis point Fed rate cut benefits Russell 2000 operating earnings by about 2%. And the market has priced out rate cut expectations for 2026. In fact, the market's recently priced in a hike but small-caps have still outperformed this year which has suggested that that relationship with Fed expectations has broken down, likely given investors confidence in the earnings recovery and the manufacturing recovery as estimates for small-caps have gotten revised up rather than down this year.

And our economist-based case is that the Fed will remain on hold this year and will begin to cut partway through 2027. So we think under this environment small-caps can continue to lead but we would focus on less levered small-caps and those with low refinancing risk. And if more Fed hikes increasingly get priced in this would make the backdrop less compelling for small-caps.

Increased geopolitical risk can also lead to volatility which tends to be negative for small-caps. Meanwhile, if the Strait of Hormuz reopens and the market believes the Fed will be less hawkish if inflation is likely to remain sticky this could be supportive for small-caps if it helps ease concerns around rates and refinancing risk. So lastly, where do we see the biggest opportunities within small and mid-caps?

At the sector level, financials and energy continue to rank well in our work particularly small-cap financials and mid-cap energy. This also aligns with our preference for value over growth where value tends to outperform during profits recoveries. We also see opportunity in small-cap healthcare.

It screens well in our work after ranking poorly for several years. M&A activity in that sector has picked up which tends to help sentiment and we're seeing stocks become higher quality there. So fewer healthcare stocks that are non-profitable, more mature companies, the median small-cap biotech stock is eight years old today versus just three to four years old in 2021.

And then at the micro level, we think focusing on stocks that benefit from some of the themes I've mentioned make sense. So manufacturing recovery beneficiaries, CapEx beneficiaries, stocks with improving earnings growth and positive revisions, and also stocks that may be able to leverage AI for efficiency gain since small caps are the most labor intensive segment of the market. Our analysts in B of A Global Research cover approximately a thousand small and mid-cap US stocks.

So lots of opportunities for stock selection. ETFs have also proliferated in small and mid-caps in recent years, which allow exposure to various styles, indices, and themes. So final thoughts, we continue to have a preference for small and mid-caps over mega caps, but we're watching the Fed and we're watching the macro, including the manufacturing recovery, and we think selectivity is important.

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