Recent data released by US banks show that the earnings growth of the S&P 600 small-cap stocks has turned positive, with an expected growth rate of 18-19% by 2026, surpassing the 13% of large-cap stocks and the 15-16% of mid-cap stocks. It's quite encouraging—after all, small-cap stocks experienced prolonged earnings contraction over several quarters in 2022-2023. Now, benefiting from the rate cut cycle, declining financing costs, and a recovery in capital expenditures, they are finally seeing a turning point.

From a valuation perspective, they are indeed cheap. Currently, the P/E ratio of small-cap stocks is 15.6 times, which is 31% cheaper than large-cap stocks. This discount even exceeds the historical average level. In 2025, institutional funds still net flowed into small-cap stocks by $6.4 billion, while net outflows from large-cap stocks reached $45 billion. This appears to be a signal of a major trend shift.

But there are issues here—once you think about it carefully, problems emerge.

First, that 18-19% growth rate is essentially a base effect. The extent of earnings decline in small-cap stocks over the past two years was severe, so the base was very low. Now, the rebound looks impressive numerically, but the actual recovery situation still warrants a question mark. Second, market sentiment has already reached an extreme bullish level. The rotation of funds from large-cap to small-cap stocks usually occurs in the late stage of a bull market or the early stage of a bear market—this timing itself should be approached with caution. Third, more practically: small-cap stocks are more sensitive to economic recessions and have higher leverage. If in 2026 the economy experiences a hard landing or rate cuts stop, the decline will definitely be sharper than that of large-cap stocks.

Honestly, this story on Wall Street has been told since 2022. Back then, everyone was saying small-cap stocks would soon outperform, mainly because of cheap valuations, imminent rate cuts, and economic recovery. But what happened? In 2022-2023, small-cap stocks kept plunging, while in 2024, large-cap stocks (especially AI-related ones) continued to surge, and small caps were still chasing behind. The real performance started around late 2025 to early 2026. During these three years, investors who stuck with small-cap stocks not only failed to make money but also missed out on those leading companies’ multiple-fold gains.

Rather than calling this a bullish recommendation, it’s more like a hedging strategy—when large-cap stocks rise too aggressively and institutions need to tell clients a new story, they bring out the "value gap" of small-cap stocks. In the short term, small-cap stocks do have relative advantages, but the overall market risk is actually accumulating.