Small-cap stocks are rallying, but here's why Wells Fargo says its better to sell than buy

MW Small-cap stocks are rallying, but here's why Wells Fargo says its better to sell than buy

By Frances Yue

The Russell 2000 is beating the S&P 500 this year, but that outperformance is masking a disturbing trend of falling earnings estimates

The Russell 2000 has outpaced the S&P 500 so far this year.

Small-capitalization stocks are finally having their moment after years of trailing the market's biggest companies. But investors may want to think twice before calling it a comeback, according to Wells Fargo Investment Institute.

The Russell 2000 index RUT of small-cap stocks has rallied 17.7% so far this year through Wednesday, outpacing the S&P 500's SPX 9.9% gain. Investors are viewing that as a sign that the stock market's rally is spreading beyond just a handful of the biggest companies, and that confidence in the U.S. economy is improving.

However, smaller companies still face a tougher fundamental backdrop, including falling earnings estimates, weaker profitability and heavier debt loads, Alex Sagal, investment-strategy analyst at Wells Fargo Investment Institute, wrote in a Wednesday note. The recent rally may be a reason to trim exposure to small-cap stocks rather than add to it, Sagal said.

"While this may suggest a turning point in relative performance, we believe this recent momentum is masking weakness in underlying small-cap equity fundamentals," Sagal wrote.

One concern is that the small-cap universe has become less profitable over time, Sagal said. About 40% of companies in the Russell 2000 do not generate earnings, up from roughly 17% two decades ago, according to Bloomberg data cited by Wells Fargo.

That shift partly reflects the growth of private-capital markets, which have allowed stronger companies to stay private for longer, Sagal noted, so when they do go public they are already valued higher. Mergers and acquisitions have also removed some profitable companies from the public small-cap market.

That has left public small-cap indexes with a larger share of younger, less profitable and more speculative companies, Sagal said. In his view, that makes it harder for the group to deliver durable earnings growth and wider profit margins.

Earnings estimates are already moving in the wrong direction. Consensus forecasts for Russell 2000 earnings have fallen 7% so far this year as of May 18, while forecasts for S&P 500 earnings have risen 8%, Sagal said.

As the chart below shows, 2026 earnings-per-share estimates for the iShares Core S&P 500 ETF IVV, which tracks large-cap U.S. stocks, and the iShares Core S&P Small-Cap ETF IJR, which tracks the S&P SmallCap 600 universe, which includes more profitable components than the Russell 2000 given its size, have increased this year, according to Dow Jones Market Data. By contrast, EPS estimates for the iShares Russell 2000 ETF IWM have fallen sharply as the year progressed, underscoring the earnings weakness in the broader Russell 2000 benchmark.

EPS growth chart, indexed at 100

That creates another problem for investors. As earnings estimates fall, valuation multiples can rise because the denominator of the price-to-earnings ratio shrinks, Sagal said.

Meanwhile, large-cap companies continue to hold a clear advantage on profitability. Small-cap stocks generated return on equity of less than 1% over the trailing 12 months through the first quarter of 2026, compared with about 20% for large-cap stocks, according to Sagal.

The margin gap is also wide. Small-cap net margins were about 4.4% over the same period, compared with roughly 14.5% to 14.8% for large-cap companies, Sagal noted.

Smaller companies carry more debt as well, with average net debt-to-Ebitda ratios near 4.5 times, compared with roughly 1.5 times for large-cap companies, Sagal said. Ebitda refers to earnings before interest, taxes, depreciation and amortization, which is a measure of underlying profitability.

With higher amounts of debt already on their books, that could leave small-cap companies with less room to maneuver when trying to raise capital if interest rates stay elevated.

-Frances Yue

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May 28, 2026 06:32 ET (10:32 GMT)

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