After five consecutive years of lagging behind large-cap peers, small-cap equities are showing signs of a potential turnaround, with recent price action and momentum indicators pointing to a shift in market rotation. Investors are reconsidering allocation strategies as the IWM index posts strong gains amid broader market resets.
- IWM has gained 12.3% YTD in 2025, outperforming SPY’s 7.8% rise
- The IWM-to-SPY ratio reached a 14-month high, indicating rotation momentum
- SML and RWR ETFs posted 14.1% and 13.6% gains, respectively
- Small-cap median P/E ratio at 16.5x vs. large-cap 24.3x
- Strongest gains in Technology and Consumer Cyclical small-cap segments
- Five-year underperformance cycle appears to be reversing
Small-cap stocks are signaling a potential inflection point after enduring a prolonged period of underperformance. The iShares Russell 2000 ETF (IWM), a benchmark for small-cap U.S. equities, has gained 12.3% year-to-date through mid-December 2025, outpacing the S&P 500 ETF (SPY), which rose 7.8% over the same period. This marks the first year since 2020 where IWM has outperformed SPY on a rolling 12-month basis, a rare occurrence during the bull market cycle that began in 2020. The reversal is particularly notable in sectors like Technology and Consumer Cyclical, where small-cap firms have demonstrated stronger earnings growth and operational agility. The VanEck Small-Cap ETF (SML) has climbed 14.1% YTD, while the SPDR S&P 600 Small Cap ETF (RWR) has posted a 13.6% return. These gains coincide with a decline in bond yields and easing inflation pressures, which have reduced the relative appeal of large-cap defensive stocks and boosted risk appetite for smaller, growth-oriented companies. Market rotation patterns suggest that investors are beginning to favor companies with higher growth potential and lower market caps. Technical indicators such as the IWM-to-SPY ratio have climbed to a 14-month high, further signaling a shift in sentiment. Analysts note that small-cap valuations remain attractively priced relative to large-caps, with median price-to-earnings ratios near 16.5x versus 24.3x for large-caps, creating a foundation for sustained outperformance if macro conditions remain favorable.