Investors entered the past year optimistic that micro-cap stocks would experience a significant rally, driven by expectations of economic resilience, supportive monetary policy shifts to monetary easing, and attractive valuations. However, the much-anticipated micro-cap resurgence failed to materialize, leaving investors puzzled.
U.S. small-cap stocks have declined just over 6% since the March rally, remaining roughly flat over the past year. Despite rising more than 20% from their 2022-2023 lows. Several key reasons underpin this underperformance:
- Absence of Anticipated Fed Rate Cuts: The expected reductions in interest rates by the Federal Reserve, which would meaningfully benefit small U.S. companies by reducing borrowing costs and stimulating growth, have not occurred. Elevated interest rates continue to weigh heavily on these rate-sensitive businesses.
- Macroeconomic Uncertainty: Initially, Trump’s agenda of deregulation and pro-growth policies was expected to boost revenue growth, lower operational costs for smaller firms, and increase mergers and acquisitions activity within the small-cap space. Instead, continuous geopolitical conflicts, increased tariffs, supply chain fragmentation, and heightened geopolitical risks have escalated uncertainties rather than mitigated them. Uncertainty undermined confidence in the smallest publicly traded companies. Investors sought safety in larger, more liquid equities that offered clearer revenue visibility
- Disappointing Earnings: Small-cap companies broadly delivered earnings that fell short of market expectations, leading to widespread negative revisions. Over 27% of Russell 2000 constituents reported negative earnings last year, significantly weakening the bullish narrative behind a small-cap rally.
- Subdue M&A activity:: anticipated surge in mergers and acquisitions that would typically boost micro-cap valuations was muted.
Over the past two decades, the Russell 2000 has steadily lost its performance edge over the S&P 500, shifting from being a historically reliable outperformer to an index driven increasingly by specific, time-sensitive factors. A significant difference lies in sector composition. Unlike the S&P 500, the Russell 2000 lacks exposure to the large-cap “FANG” or “Magnificent 7” stocks, which constitute nearly one-third of the S&P 500. These mega-cap companies, benefiting from monopoly-like positions within the enterprise ecosystem, have consistently delivered exceptional performance.
In contrast, the Russell 2000 emphasizes cyclical sectors such as Industrials, Financials, Materials, and Energy, along with interest rate-sensitive sectors like Real Estate and Utilities. Due to this weighting difference, small caps primarily represent “Main Street,” whereas large caps reflect global technology disruptors. Consequently, the correlation between small and large caps has declined notably, from over 90% around the Global Financial Crisis to approximately 70% today.
Additionally, concentration levels differ significantly. The S&P 500 is highly concentrated, with the top 10 holdings representing over one-third of the index’s weight, compared to only 4% for the Russell 2000. This fundamental distinction further explains the divergence in performance trends between small and large-cap indices. Furthermore a large proportion of companies have consistently reported negative earnings, and are highly leveraged with significant debt burden, further reflecting structural profitability challenges within this market segment.
Due to their higher sensitivity to economic conditions, weaker profitability, and greater susceptibility to external shocks, these smaller companies often require deeper fundamental analysis. Active managers can help to identify resilient businesses, and avoid weaker ones while navigate volatility related to macro factors.