The current outperformance of small-cap stocks is driven by several factors, and the "January effect" plays a historical role in this trend.

Factors Contributing to Small-Cap Outperformance

Improving Macroeconomic Outlook: Stronger-than-expected economic data is reshaping the earnings outlook for smaller firms. The Atlanta Fed's GDPNow model estimated the U.S. economy grew at a 5.3% annualized rate in the fourth quarter, a pace not seen outside the post-pandemic period since mid-2014. Resilient household consumption and robust business investment indicate underlying strength.

Stronger Earnings Revisions: Small-cap earnings revisions have significantly improved ahead of earnings season, outperforming large- and mid-cap revisions. The percentage of small-cap companies raising guidance ahead of fourth-quarter earnings surged, a rare occurrence not seen since January 2025, historically preceding sustained small-cap outperformance. Steven DeSanctis of Jefferies forecasts small-cap earnings to grow by 14.6% for 2026, surpassing large-cap growth of 13.8%.

Attractive Relative Valuations: Small-cap stocks are trading at historically cheap levels compared to large caps. The S&P 500 has an average price-to-earnings (P/E) ratio of 31, while the Russell 2000 has an average P/E of just 18, indicating potentially better value for small caps.

Expectation of Lower Interest Rates: Small-cap companies tend to be more sensitive to changes in interest rates and credit conditions due to their reliance on debt. The likelihood of interest rate cuts by late April is forecast at 61%. Favorable credit conditions and expected easing of interest rates in 2026 could act as a catalyst for higher small-cap stock prices.

Domestic Economic Advantages: Small-cap companies generate a larger percentage of their revenues domestically, positioning them to benefit disproportionately from trends like reshoring and infrastructure build-out.

AI as a Second-Order Beneficiary: While large tech firms lead AI infrastructure, small caps could benefit from AI-driven productivity gains, as identical efficiency improvements can lead to significantly larger percentage earnings growth for companies with lower average operating margins..

Increased Market Activity: Analysts expect an increase in mergers and acquisitions (M&A) and a recovering IPO market in 2026, which can create "large idiosyncratic returns" within the small-cap universe.

Historical Cyclicality: While small-cap stocks have trailed large caps for 15 years, this is considered an historical anomaly, as periods of small-cap and large-cap outperformance generally last 6 to 16 years. Many analysts forecast the end of large-cap dominance in 2026, with small caps reclaiming market leadership.

The "January Effect"

The "January Effect" is a historical market pattern where stock prices, particularly those of smaller companies, tend to rise more in January than in other months. This phenomenon is often attributed to:

Year-end tax-loss selling: Investors sell underperforming stocks in December for tax-loss harvesting, which can depress prices. They then repurchase these or other small-cap stocks after the New Year.

New-year inflows: Inflows from retirement contributions, bonuses, and fund rebalancing often chase recent winners, extending momentum early in the year. Fund managers reset portfolios and make new bets in January, often adding high-momentum names.

In early 2026, the small-cap Russell 2000 index has significantly outperformed, with IWM up more than 7% year-to-date, sharply outpacing the S&P 500's modest 1.5% gain as of January 15. This strong start has been observed as a potential return of the "January Effect".