Russell 2000 rally: sustainable or ‘January effect' only?

• Small-cap stocks are trading at a roughly 30% discount to large caps on a forward P/E basis, while small-cap earnings growth has surpassed larger companies for the first time in over three years
• Expected Federal Reserve rate cuts would particularly benefit smaller companies due to their heavier reliance on borrowing compared to large-cap peers
• Historical patterns suggest small caps tend to outperform in February, especially during midterm election years like 2026, supporting analyst projections for continued upside

Russell 2000 Rally: Sustainable or January Effect Only?

Key Performance Metrics

The Russell 2000 small-cap index has surged approximately 8% year-to-date in 2026, with nearly double-digit gains in January alone, significantly outpacing the S&P 500. The index has printed new highs as investors rotate away from potentially overvalued large-cap AI stocks in what experts call the "Great Rotation."

Market Drivers and Analysis

According to Jeffrey Hirsch, senior editor at Stock Trader's Almanac, several factors are fueling the rally:

• Monetary Policy: Expectations of Federal Reserve rate cuts in upcoming meetings favor small-caps due to their greater reliance on borrowing
• Seasonal Factors: The "January Effect" drives investors toward smaller stocks after tax-loss selling pressure in Q4
• Valuation Gap: Small-caps trade at a 30% discount to large-caps on forward P/E multiples

Fundamental Improvements

Portfolio manager Daniel Lysik notes small-cap earnings growth has surpassed larger companies for the first time in over three years. Historical data shows small-caps typically outperform in February, with advantages amplified during midterm election years like 2026.

Market Implications

The rotation suggests investors are seeking diversification from overextended tech stocks and pursuing value opportunities. If rate cuts materialize and economic growth remains stable, small-caps appear positioned for continued outperformance.

Analysts believe the deep valuation discount and improving fundamentals could attract value-seeking investors who have overlooked smaller firms during the AI-driven rally in large-caps. The sustainability of this trend will depend on Federal Reserve actions and broader economic conditions through 2026.