This Expert Says Small Caps Will Outperform This Year—and Two More 'Surprises' to Watch

• Small-cap earnings estimates for 2026 exceed large-cap projections, with declining interest expenses boosting profitability as the Fed continues rate cuts expected to begin in June
• Healthcare stocks present a 'compelling' opportunity trading at depressed valuations near a 40-year low weight in the S&P 500, with only $537 million in ETF inflows versus $10.6 billion for industrials
• Investors appear caught off guard by small-cap strength after withdrawing $12 billion from small-cap ETFs, potentially missing the sector rotation amid January's positive performance indicators

Summary: Small-Cap Stocks Poised for Outperformance in 2026

Key Predictions:

State Street chief investment strategist Michael Arone forecasts three market "surprises" for 2026:

1. Small-cap stocks will outperform large-caps
2. Healthcare stocks will beat the broader market
3. Inflation will undershoot expectations

Small-Cap Outlook:

After nine years of underperformance, small-cap stocks (market cap below $2 billion) show early strength, with the Russell 2000 up 8% year-to-date, outpacing the Russell 1000 and S&P 500. However, investors remain skeptical, withdrawing $12 billion from small-cap ETFs over the past year through January.

Supporting Factors:

• Declining interest expenses as the Fed continues rate cuts (next cut expected June 2026)
• Small-cap earnings estimates for 2026 exceed large-cap projections
• Weaker dollar and deregulation boosting IPO activity
• January market folklore suggesting positive full-year performance

Healthcare Opportunity:

The healthcare sector trades at a 40-year low weight in the S&P 500, creating "compelling" value opportunities. The Health Care Select Sector SPDR ETF (XLV) delivered second-lowest returns over five years but shows improved positioning. Healthcare ETFs saw only $537 million in inflows over 12 months, compared to $10.6 billion for industrials.

Inflation Outlook:

Despite elevated oil prices driven by geopolitical tensions, Arone expects these increases to be "short-lived," with tariff-related price pressures subsiding by mid-year. January CPI data due Friday should provide further clarity on the inflation trajectory.