As the dust settles on another dramatic year in the stock market, small-cap equities face mounting challenges that have shaken investor confidence. While broader indices grappled with mixed returns, the Morningstar US Small Cap Extended Index plunged 23% from its postelection high on November 25, 2024, through April 4, 2025. That drop officially ushered small caps into bear market territory, underperforming the S&P 500 and Russell 2000 benchmarks.

Investors who once applauded the nimble, high-growth potential of smaller companies now find themselves questioning whether the allure of stability in large-cap names is simply too powerful in uncertain times. Yet beneath the surface of this cycle lies an opportunity for those who remain keenly aware of market rhythms and valuation extremes.

Understanding the Underperformance of Small Caps

Small-cap stocks have not outperformed broad indices since 2016, marking a cyclical downturn of roughly 13 to 14 years—slightly above the historical average of 12 years for such cycles. Several factors explain this sustained lag:

• Economic Sensitivity: Smaller companies typically earn a larger share of revenue domestically, making them vulnerable in late-cycle or slowing growth scenarios.
• Interest Rate Exposure: With higher leverage and more floating-rate debt, many small caps have seen borrowing costs surge as central banks maintain elevated policy rates.
• Structural Headwinds: The rise of lower-quality entrants in the small-cap universe, combined with the best startups staying private longer, has diluted overall performance.
• Flight to Stability: Amid macroeconomic uncertainty, investors have crowded into mega-cap names perceived as safe havens, leaving smaller firms in the cold.

The Reign of the Mega Caps

In stark contrast, a handful of large-cap leaders—often dubbed the “Magnificent Seven”—powered the S&P 500’s gains. These tech giants achieved 30% earnings growth in 2024 and are forecast to deliver 20% growth in 2025. Their sheer size and cash generation foster a perception of resilience, drawing capital away from riskier segments.

This narrowing of market leadership has produced some of the widest valuation gaps on record. While large-cap price-to-earnings multiples have expanded, small and mid caps trade near multi-decade lows relative to the S&P 500. For many, this signals a potentially fertile ground for rebalancing portfolios.

Looking Ahead: Potential for a Small-Cap Comeback in 2025

Despite recent struggles, the outlook for smaller stocks is not uniformly grim. Analysts predict that small- and mid-cap earnings, which were down in 2024, may swing to double-digit positive growth in 2025. This forecast rests on improving economic conditions, stable interest rates, and the eventual plateau of mega-cap valuation multiples.

History suggests that extreme performance disparities between large and small caps often precede multi-year stretches of outperformance for smaller names. With mega-cap valuations stretched and economic data hinting at stabilization, the stage is set for a possible rotation toward undervalued smaller stocks.

Strategies for Investors

For those seeking to navigate this evolving landscape, a balanced approach can yield both protection and upside potential:

• Diversify across market caps: Allocate a thoughtful portion of equity exposure to small and mid caps to capture potential rebound gains.
• Maintain valuation discipline: Look for companies trading below historical averages on price-to-earnings or price-to-book metrics.
• Consider active management: With greater dispersion in smaller stocks, skilled managers can add alpha by identifying mispricings.
• Monitor macro drivers: Keep an eye on interest rates, inflation, and GDP growth to time portfolio adjustments prudently.

Embracing Opportunity Amid Uncertainty

While recent performance has favored the giants of the market, every cycle eventually turns. As Peter Carpi of Wellington Management notes, “The greatest gains tend to occur at cycle turns, and we’re approaching a point where small caps look attractive.” Greg Garabedian of the same firm highlights that small- and mid-cap valuations are at historic lows relative to large caps—suggesting a potential regime shift in 2025.

Investors who remain patient and alert to valuation extremes may find that the tide shifts in their favor. By blending prudent risk management with a willingness to seize bargain valuations, portfolios can position themselves to benefit from the next phase of growth.

Ultimately, the story of small caps lagging as investors favor stability may soon evolve into one of resurgence. History teaches that market leadership rotates, and those ready to act when the cycle turns often reap the richest rewards. With 2025 on the horizon, the case for small-cap participation has never been stronger—for both the cautious and the opportunistic alike.