Small stocks have crushed big ones this year, but that may just be a mirage

By Mark Hulbert

Small-cap investors are convinced the stock-market tide has turned in their favor

Small-cap stocks are off to a strong start in 2026. But investors shouldn't get carried away just yet.

Small-cap's relative strength doesn't have longer-term significance because it is caused by short-term seasonal factors.

Small-cap stocks are having a great start to the year, but that doesn't mean their performance will get bigger from here.

It's understandable why long-suffering small-cap investors are so eager to declare that the tide has turned in their favor. Despite numerous past studies finding that small caps have significantly outperformed large caps over the past century, small stocks on average have suffered for some time.

Over the 20 years through the end of 2025, for example, the Russell Top 200 Index XX:RT200 of the 200 largest stocks in the Russell 1000 Index RUI beat the small-stock Russell 2000 RUT by 3.5 percentage points annualized. And it outperformed the Russell Microcap Index of the smallest of the small caps by 4.7 annualized percentage points.

But this year through Jan. 20, the Russell Top 200 has lost 1.3% versus a 6.6% gain for the Russell 2000 and 7.6% for the Russell Microcap Index.

Small caps' relative strength doesn't have longer-term significance because it is caused by short-term seasonal factors. One such factor is that tax-loss selling - investors selling losers to offset any capital gains - came to an end in December. That selling disproportionately impacted smaller stocks, which helps to explain why they have bounced back so strongly this year. Another short-term seasonal factor is that large institutional investors have an incentive in early January to shift some of their equity exposure away from the largest stocks and into the smallest issues (as I discussed in a column last fall).

To document that early-January small-cap returns don't have long-term significance, I calculated the Russell indices' returns over the first two weeks of each of the past 20 calendar years. Even though the larger-cap indices came out far ahead of the smaller-cap benchmarks over the entire 20-year period, the reverse was true for the first two weeks of January: On average over this two-week period, the Russell Microcap's return was higher than those of the Russell mid-cap and large-cap indices.

Are small stocks really undervalued?

Many small-cap investors also make a valuation-based argument for why they believe that small-cap relative strength so far this year portends something more sustainable. But there are flaws in this argument: On average small-cap stocks are more overvalued than the largest issues.

Consider how the price/earnings ratio is calculated for an index that contains companies that are losing money, which is the case with many smaller companies. Many index providers simply ignore these losing stocks, which can artificially lower the index's reported P/E ratio. When excluding companies with negative earnings, for example, the Russell 2000 index of small- and mid-cap stocks recently had a P/E ratio approaching 20.0 - well-below the S&P 500's SPX nearly 26.0 P/E ratio. But when losing companies are included in the calculation, as they should be, the Russell 2000's P/E ratio jumps to about 37.0.

The bottom line? Small-cap stocks may beat the large caps in 2026. But whether they do so has nothing to do with their performance this year so far.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

Also read: Tax-related selling could set up these 11 stocks for big gains early in 2026

More: These under-the-radar stocks combine fast growth with big upside potential

-Mark Hulbert

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01-24-26 1527ET