In this article, we review:
- Factors that could drive rotation from large-cap stocks to small-cap stocks, which have underperformed in recent years
- Past periods of small-cap outperformance when macroeconomic conditions were favorable
- The argument investor risk appetite and a small-cap rotation could be sustained by conditions like cooling inflation and Fed easing
Following a lengthy period of meaningful large-cap outperformance, it’s natural to question when asset flows will move down the market cap spectrum in a significant way. This article addresses the question, investigating the likely drivers of an eventual small-cap rotation and where on that road we believe we are today. Small caps as an asset class have made a few attempts at grabbing firm market leadership in recent years, but have failed as conditions discussed below proved unsustainable. Those attempts, however short-lived, inspire confidence about investors’ proclivity to return to small caps when those conditions reoccur on a more stable basis.
The large-cap dominance of recent years began as Big Tech enjoyed tailwinds from the economy’s technological transition to accommodate hybrid and fully remote work models early in the COVID-19 pandemic. Large caps, led by Big Tech, benefited once again as the evolution of generative artificial intelligence (AI) has captivated users and investors alike over the past two years. While we’re big believers in AI and the sustained buildout of the infrastructure that supports it, the volatility experienced following news of DeepSeek’s purported technological breakthroughs provided a reminder that in the long run, everything can become commoditized. That’s a concern when valuation multiples of 40–50 (or more) times earnings are justified only by the staying power of these technology trends. Just as this dynamic has advantaged large-cap companies, small-cap stocks stand ready to benefit once investors more rationally price these risks and redeploy assets into equity classes with better risk/reward dynamics.
The chart below depicts the yin and yang of small- and large-cap stocks over time. The intermittent outperformance of each resembles the movement of a pendulum, with extreme periodic returns quite common for each class.
As of December 31, 2024. Source: FactSet and FTSE Russell
Historically, the rhythm of the pendulum has been dictated by the macroeconomic cycle. Small-cap stocks tend to underperform going into economic downturns and outperform coming out of them. This is mostly due to the high financial and operating leverage characterizing small-cap companies. (We speak broadly about the asset class here but remind investors that Systematic seeks to minimize risk associated with this financial leverage through our quality-first strategy, emphasizing strong free cash flow, and robust balance sheets.) While this leverage hurts profitability and elevates risk as recessions take shape, the opposite is true as cyclical recoveries ensue. When downturns give way to the green shoots of macroeconomic recovery, investors historically gravitate to the shares of small-cap companies.
Small caps rallied, for instance, following the re-opening of the economy after the COVID-19 shutdowns. The brief COVID-19 recession gave way to the return of animal spirits and risk-taking, a trend catalyzed by the introduction of the first COVID-19 vaccines. As the pendulum swung, small caps benefited from a powerful asset rotation — but that benefit was cut short by the onset of inflation and resultant fears of higher interest rates and a potential recession. As portrayed in the chart above, large caps regained leadership amid the rise of generative AI and the prevalence of large learning models, which advantaged companies like Nvidia, Microsoft, Meta, and other big-cap, growth entities with the deep pockets to fund massive AI investments.
Small caps attempted to regain market leadership in the summer and fall of 2024. Unlike typical small-cap rallies driven by green shoots at the beginning of economic cycles, these 2024 stock moves occurred as investors applauded the Fed’s apparent engineering of a successful mid-cycle soft landing. The psychological influences that boosted the small-cap asset class for brief periods in 2024 are essentially the same as those that drive the class higher amid typical early cycle scenarios: when the economic outlook brightens, investors tend to shed their risk-aversion and recession fears, prompting them to rotate into small caps for their greater financial and operating leverage — and higher expected returns. The embrace of risk in late-summer 2024 coincided with a less-hawkish monetary stance at the Federal Reserve, which would soon undertake 100 basis points of rate cuts. The lower cost of debt capital further emboldened the small-cap investor in the summer and fall of 2024.
The bull ran down Wall Street again immediately following the 2024 U.S. presidential election, when investor sentiment was lifted by hopes for lower taxes and de-regulation. In the ensuing weeks, though, the mood quickly changed. As ebullient emotion waned, cynicism — about key executive branch nominees, tariff uncertainty, lack of clarity about fiscal policy, and the Fed’s pivot to a holding pattern on monetary policy — grew. One catalyst of the drawdown in the weeks following the election was the planned forming of the Department of Government Efficiency — and the choice of Elon Musk to co-lead it — which prompted investors to reassess the sustainability of stimulative fiscal tailwinds. As the quarter unfolded, meanwhile, it became apparent that higher tariffs could be imposed just as the downtrend in inflation was flattening, a worrisome potential combination.
We believe investors may benefit from having a long-term perspective, looking upon the post-election selloff as an opportunity to gain exposure to the same dynamics that drove the initial beginnings of an asset rotation last year. The recent inflation data are reminiscent of the temporary pickup in inflation that spooked markets early in 2024, before both the Consumer Price Index and the Personal Consumption Expenditure deflator quickly resumed their declines as the year progressed. We’ve always favored the investing tactic of exploiting short-term departures from meaningful longer-term trends and underscore the point that the recent investor angst could be setting investors up for another bite of the apple before small caps regain leadership again. The catalyst for that could be some combination of inflation cooling, the Fed lowering interest rates again, and/or some policy clarity emerging from the Trump Administration. More broadly speaking, investors need confidence that a fiscal or monetary policy error will not derail the economic expansion before gaining comfort with the small-cap trade again.
The focus today is on tariffs, given their likely inflationary effect (even if temporary). President Trump is clearly using the threat of tariffs to extract optimal geopolitical gain from trading partners, but how far he will go in codifying protectionist policy is uncertain. There were signs of optimism in the first weeks of his taking office, with Canada and Mexico both offering concessions to stave off tariff threats. As to the ultimate policy actions behind the rhetoric, the President has always viewed the stock market as an arbiter of his performance. While there will almost be incremental tariff activity in the months ahead, it’s likely to be balanced against his desire to support the economic and financial markets. We see small-cap stocks working well as clarity on geopolitical policy is gained.
In summary, small-cap stocks tend to outperform when macroeconomic conditions are favorable, and confidence in the economy emboldens investors to reach for the extra potential returns available from companies with higher operating and financial leverage. Last year’s activity, during which small caps surged in fits and starts before retreating as risk aversion about geopolitics and inflation intensified, demonstrates to us the potential for a powerful small-cap rally during 2025. The exact timing of such an asset rotation is difficult to predict, but we believe investors need to be exposed ahead of time. We hope this commentary provides investors with a framework for how to interpret macroeconomic data points in the months ahead. Past small-cap rallies have been quite lucrative. Investors are urged to do their due diligence now, so they are not left behind when the recent macroeconomic clouds begin to clear and sentiment toward the small-cap asset class likely improves.
About the author
Rick Plummer is a member of the Systematic portfolio-management team, which is responsible for the day-to-day management of client portfolios and the maintenance of proper risk controls. He also has analytical responsibilities, conducting company-specific fundamental research within selected economic sectors spanning the market cap spectrum.
Rick joined Systematic in 2004 from Value Line Investment Survey, where he served as a senior industry analyst and lead editor of the firm’s daily stock reports. He also spent time in Value Line Asset Management as a portfolio manager for private wealth clients.
Rick holds the Chartered Financial Analyst® (CFA®) designation and is a member of both the CFA Institute and CFA Society New York. Rick received his MBA. in finance at New York University’s Stern School of Business, with Stern Scholar honors, and a bachelors in economics and government from Wesleyan University.
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