The rally in small caps, as measured by the S&P 600 Index since the April 2025 lows, can easily continue into 2026. Whether a sustained advance will come to fruition will be almost entirely dependent on the economy, specifically sentiment towards a soft landing, writes Tom Essaye, president of the Sevens Report.
I say that because the reason that the S&P 600 meaningfully underperformed the S&P 500 Index (^SPX) through the H125 market drawdown, with the former falling about 30% while the latter fell only 20%, was due to inflation fears. That, in turn, resulted in a “higher-for-longer” Federal Reserve policy stance.
S&P 600 Index (^SML)
Data by YCharts
The best-case scenario for small caps to extend the rally off the April 2025 lows is for more of the same from the economy and Fed, with the soft-landing narrative remaining intact while AI enthusiasm moderates. In that environment, we would likely see a significant, continued rotation away from the extremely concentrated leadership names in the S&P 500 and into the rest of the market.
Earnings growth potential could then spread to other industries and sectors, as opposed to currently being so concentrated in AI/mega-cap tech. Lower rates and resilient growth can support more than just the few names sensitive to rapidly growing and quickly evolving AI technology and the data centers that support it.
