Why the record rally for small-cap stocks could run into a big problem in 2026

By Isabel Wang

Rising Treasury yields could be an roadblock for small caps, but fundamentals finally have started to improve, says one money manager

Rising bond yields could be a problem for small-cap stocks' recent rally to record levels.

Wall Street has finally turned bullish on small-caps stocks - with the Russell 2000 index recapturing record territory last week, helped along by optimism over the Federal Reserve's interest-rate policy.

Yet recent increases in Treasury yields and a cooling outlook for the Fed's monetary policy next year have been quietly tightening the screws on this popular corner of the equity market, where many companies in the group remain unprofitable.

Smaller public companies have been thriving this year in an economy that finally seems to be rewarding them with lower interest rates, steady economic growth and investors hungry for risk. Small caps, as represented by the Russell 2000 RUT, have risen over 13% so far in 2025, topping the Dow Jones Industrial Average's DJIA 12.4% year-to-date gain, according to FactSet data.

The strength in small caps has continued into the final month of the year on hopes that the Fed will lower interest rates by another quarter of a percentage point on Wednesday. The move would mark the central bank's third rate reduction this year, following its September and October cuts, and bring the federal-funds rate down to a range of 3.50% to 3.75%.

However, investors are weighing whether the momentum in small caps can persist, given growing broader uncertainty around the Fed's likely policy trajectory in 2026 and, more notably, the rise in Treasury yields.

Longer-term Treasury yields climbed to their highest levels since September on Monday, as fed-funds futures traders dialed back expectations for both the timing and depth of the Fed's easing in 2026 - with no rate cut priced in until at least April, according to the CME FedWatch Tool.

The benchmark 10-year Treasury yield BX:TMUBMUSD10Y was up 3.3 basis points to 4.171% on Monday afternoon, while the 30-year rate BX:TMUBMUSD30Y was up nearly 3 basis points, at around 4.815%, according to FactSet data. Bond yields and prices are inversely related.

See: The Fed meeting this week will determine if investors get new all-time highs or coal for Christmas

Brian Mulberry, senior client portfolio manager at Zacks Investment Management, said that while a rate cut this week is pretty much baked into the cake, the market story could "change significantly" next year, with Fed Chair Jerome Powell stepping down at the end of his term and Atlanta Fed President Raphael Bostic retiring. Mulberry said rising longer-term Treasury yields on Monday were reflecting that uncertainty.

Focus on the Fed after Powell

A revamped Fed could provide consistent monetary policy and a lower interest-rate environment next year, but between now and then, views within the central bank appear to be split, Mulberry said in a phone interview Monday.

Small-cap stocks tend to benefit the most from near-term Fed easing because many companies rely on short-term or floating-rate debt to finance their businesses. When interest rates fall, these companies can refinance sooner at typically lower borrowing costs, which potentially could boost their earnings more quickly than large-cap companies.

But while a company's borrowing costs are influenced by shorter-term rates, rising long-term yields still can shrink the present value of its future earnings - a particular challenge for small caps, whose profits are often further out on the horizon.

Of course, not all small-cap companies are the same. The proportion of unprofitable companies within the Russell 2000 index has climbed back to levels last seen during the post-financial-crisis shakeout.

Torsten Slok, chief economist at Apollo Global Management, has noted that roughly 40% of stocks in the Russell 2000 didn't turn a profit over the past year (see chart below). A MarketWatch analysis of FactSet data also found that just under 40% of Russell 2000 member firms reported negative net income during the most recent quarter.

SOURCE: BLOOMBERG, APOLLO CHIEF ECONOMIST

"The amount of profitable small-cap companies will only likely go down if interest rates don't go lower substantially," Mulberry said. "As the cost of capital rises, it certainly makes the value of those future earnings worth less, so there's no doubt about that impact on small caps."

Status check on earnings recession

Despite the uncertain rate backdrop, Wall Street has been growing increasingly bullish about the ability of small caps to extend their rally next year.

One of the more notable voices is Morgan Stanley's chief U.S. equity strategist and chief investment officer, Mike Wilson. He was Wall Street's most vocal bear in 2022 and 2023, and has now returned as a strong bull on stocks.

His team recently upgraded small caps to overweight, saying the group has "shown relative strength" and stands to benefit from "an early-economic-cycle backdrop, stabilizing earnings revisions, positive operating leverage and lower rates" in 2026.

According to Francis Gannon, co-chief investment officer and managing director at Royce Investment Partners, a money manager focused on small-cap stocks, rising Treasury yields may no longer pose the same risks to small caps as they once did, now that their fundamentals have finally started to improve.

"For a period of time, small caps have been in an earnings recession, but that has seemingly come to an end in the third quarter. Our anticipation is that [earnings are] going to continue and be powerful throughout the fourth quarter and into next year, and exceed large-cap earnings growth," Gannon told MarketWatch via phone on Monday. "The market's going to focus more on the underlying earnings and corporate fundamentals within small caps, and thus they probably won't be as paralyzed by the bond market."

Gannon said small caps will see "better and accelerating earnings growth" in 2026. As of the end of the third quarter, the combined two-year earnings growth for the Russell 2000 in 2025 and 2026 was projected at 77.8%, compared with just 25.7% for the large-cap Russell 1000 RUI, according to data compiled by Royce Investment Partners.

U.S. stocks were mixed on Tuesday. The S&P 500 SPX dipped 0.1% and the Dow Jones Industrial Average declined 0.4% while the Nasdaq Composite COMP advanced 0.1%.

-Isabel Wang

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12-09-25 2102ET