Let’s face it — small caps haven’t had it easy. While mega-cap tech stocks were busy driving the S&P 500 to all-time highs, smaller companies were stuck playing second fiddle. Since 2015, the Russell 2000 has delivered less than half the gains of its large-cap counterpart. That’s a long time to be lagging.

Performance of S&P 500 vs MSCI World Small Cap vs Russell 2000 (2015–2025)

Source: FE Analytics. All indices are total return in US dollars. Past performance is not a reliable indicator of future performance. Data as of 30 June 2025.

And yet… maybe this is exactly why things could turn. Markets move in cycles, and the cycle for small caps? It’s been stretched thinner than usual. Now, in 2025, some fresh tailwinds may finally be lining up.

Valuation: The Discount Is Hard to Ignore

Start with price. The S&P 500 is sitting north of 22× forward earnings. The Russell 2000? 17.52.

Sure, a lot of small-cap names are still unprofitable. That’s baked in. But even if you strip out the loss-makers, the earnings yield (that’s just earnings / price) on small caps looks far more appealing than their larger cousins.

Put bluntly: investors are paying up for the big names, and ignoring the little ones. That doesn’t last forever.

Macro Tailwinds: Lower Rates, Weaker Dollar, Stronger Growth

If interest rates fall as expected this year, small caps may feel the boost first. Many rely on floating-rate debt, so even a modest cut can improve margins. It’s one of the clearest arguments for a recovery in this part of the market.

There’s also the currency angle. The US dollar has softened in 2025, which tends to benefit smaller domestic firms more than multinationals. Around 80% of Russell 2000 revenue is earned within the US, so these companies aren’t as exposed to currency swings or geopolitical tension.

Then there’s earnings. Forecasts for small-cap earnings growth in 2025 hover around 20%, well ahead of large caps. If the economy manages a soft landing or stable expansion, these projections could prove conservative.

Sector Breakdown: Where the Strength May Come From

Small-cap indices lean heavily into cyclical sectors like industrials, financials and healthcare. These areas tend to benefit first when the economy stabilises or reaccelerates. Regional banks, for instance, could see a margin lift as credit conditions ease. Biotech names with real pipelines may get a second look from investors chasing innovation outside Big Tech.

In other words, small caps are far from one homogenous block. They span dozens of industries, and some are better placed than others to ride the next wave of growth.

Risks: Still a Bumpy Ride

None of this is to say small caps are a sure bet. They remain volatile. They trade on thinner volumes. And when the economy wobbles, they often fall harder than large caps. Even with rate cuts, financing conditions could stay tight, which is a challenge for companies already running lean.

And let’s be honest: investor appetite hasn’t fully returned yet. With capital still flowing into the same familiar large-cap names, it may take a clear catalyst to trigger a full-blown rotation.

Strategic Takeaway

So, are small caps ready to outperform in 2025? The case is building. Valuations are low, growth potential is rising, and macro conditions are shifting in their favour. But timing matters. This isn’t about making a big bet; it’s about recognising that cycles turn, and this one is due.

For long-term investors, a modest allocation to high-quality small-cap stocks could offer not just diversification, but genuine upside. The road may be bumpier, but for those willing to stomach the swings, 2025 might just be the year small caps step out from the sidelines.