Rise of the Small Caps: How Wall Street’s Discount Companies are Thriving in 2026
Wall Street may have been dominated by mega-cap stocks in recent years, but it's the smaller capitalization companies that have been making waves in 2026. What’s driving this new investor appetite for discounted equities?
The artificial intelligence boom has been a driving force for US high-tech stocks, with blue chips rallying beyond the $4 trillion and $5 trillion valuation boundary for the first time in 2025 alone. But this year the outlook for the Magnificent Seven and other large-cap stocks appears to be more subdued.
Instead, it’s their small-cap counterparts that are making headway. The Russell 2000 index, which is comprised of the 2,000 smallest stocks within the larger Russel 3000 index, recently reached new all-time highs and has comfortably outperformed the S&P 500 and Roundhill Magnificent Seven ETF (MAGS) this calendar year.
Up around 20% in 2026, the Russell 2000 has already surpassed 3,000 for the first time in its history and has left the 12.5% growth posted by the S&P 500 and 5% uptick by MAGS eating its dust.
This is far from a common trend in the United States. Since 2017, the Russell 2000 has only posted higher annual growth rates than the S&P 500 once. In the age of AI hyperscalers, few market analysts would’ve anticipated the rise of the small caps. So what’s driving this year’s trend?
Why are Small Caps Winning?
There are a few factors driving the turnaround in fortunes of small-cap stocks, and Lori Calvasina of RBC Capital Markets suggested that the combination of below-average valuations and stronger bottom-up earnings growth outlooks has added to many economic tailwinds, including a reacceleration in job growth and manufacturing activity, which is helping to support the performance of the Russell 2000.
“The second quarter of 2026 brought a show of strength for small-cap stocks while trading for Mag7 stocks turned choppy, indicating that spells of profit-taking among investors helped to support smaller stocks as concerns over the high valuations of hyperscalers entered the fray,” explained Vsevolod Smirnov, CMO at Just2Trade.
“Although this doesn’t mean that large-cap stocks will continue to underperform in the second half of the year, it does highlight legitimate concerns over the sheer size of Wall Street’s largest players following multiple years of parabolic growth.”
Small caps may be winning, but there are still some challenges that could create doubt over a continuation of their outperformance.
Smaller companies can be especially sensitive to interest rates, which could lead to a period of subdued trading. With this in mind, the long-term outlook for the Russell 2000 may depend on avoiding any further escalations in the war in Iran and the Fed’s monetary policy changes.
With markets pricing in a 60% chance of a rate increase during the Federal Reserve’s September meeting, the second half of 2026 may be bumpier for small capitalization stocks.
Investors Hold Breath on Capex
The success of small caps has also been pushed further into the spotlight by mega-cap stagnation and particularly by heightened periods of volatility among AI hyperscalers.
Investors have grown increasingly concerned about capital expenditures among S&P 500 leaders, particularly as more firms appear focused on building out their artificial intelligence infrastructure.
Magnificent Seven spending on capex is expected to hit $750 billion in 2026 alone, which is eating into the free cash flow of major Wall Street players.
Google parent Alphabet recently raised its capex guidance for the year to $195 billion to $205 billion, up from an initial range of $180 billion to $190 billion.
The stock itself has since recovered from the shock of the revision, but with a trailing price-to-earnings (TTM) ratio of around 18.5x based on past 12-month earnings, these high levels of spending could cause further friction for investors who will soon be looking for tangible evidence of these high-value stocks living up to their expectations.
However, more bullish analysts will argue about the exceptional circumstances surrounding the AI boom. With the World Economic Forum estimating that AI could contribute up to 14% of global GDP by 2030 at a value of around $15.7 trillion, there’s a case to be made that the reward for spending today could pay dividends later on.
What’s Next for Small Caps?
The Russell 2000 has been thriving on profit-taking for investors seeking to cycle out their AI earnings into discounted stocks, but there will be some important tests in the coming weeks to help shine a light on what’s next for small caps.
The first test will be the Fed’s decision on interest rates in September. Because smaller companies are more vulnerable to rate changes, a hike could deliver a correction. However, if this doesn’t happen, then it could be a bullish indicator that small caps are ready to continue closing the gap to their larger counterparts.
As has been the case since Q4 2022, the artificial intelligence boom will also be decisive. Any further signs of friction could see more profit-taking in a way that would drive small caps higher. Capex could play a key role in the direction that small companies take in the coming months.