Small-cap stocks have historically provided a fertile ground for growth, but recent market turbulence has exposed vulnerabilities that large caps have weathered more successfully. From late 2024 into 2025, the gap between small and large companies has never looked wider—and understanding why this happens can light the path forward for investors navigating uncertainty.

Recent Performance: A Widening Divide

The small-cap benchmark, as measured by broad indices like the Russell 2000 and the S&P SmallCap 600, fell 23% from postelection high on November 25, 2024, through April 4, 2025, officially entering bear market territory. In early April alone, the S&P SmallCap 600 dropped nearly 15% from April 2 to April 8—outpacing losses in mid and large caps by several percentage points.

While large-cap benchmarks such as the S&P 500 and Nasdaq 100 showed greater resilience, small caps underperformed by a cumulative 103% and 332% respectively over the past decade. A modest rebound of nearly 20% for the S&P SmallCap 600 from April 8 to June 24, 2025, offered brief relief but left absolute valuations and sentiment stubbornly depressed.

Historical Precedents and Long-Term Context

Episodes of such severe small-cap underperformance have only been seen three times before in the last century: 1931, 1974, and 1999. Each historical trough was followed by a sustained rebound in smaller companies, suggesting that these selloffs can spark fertile conditions for future gains.

Why Small Caps Falter in Stress

Several interconnected factors conspire to make small-cap stocks particularly vulnerable during market stress:

• Domestic economic cycles—small firms are more exposed to U.S. policy shifts and fiscal changes.
• Thin profit margins—smaller companies struggle to absorb cost increases from inflation and wages.
• Interest-rate sensitivity—higher funding costs hit leveraged small caps harder.
• Geopolitical uncertainty—tariffs and trade disputes introduce uneven headwinds.

These dynamics are exacerbated by sector composition: technology stocks command roughly 30% of the S&P 500 but represent just 10% of the Russell 2000, leading to capital flows that favor mega-cap momentum over smaller, domestic-oriented names.

Valuation Discount and Market Metrics

The valuation gap between small and large caps has never been more pronounced. As of late June 2025, the S&P SmallCap 600 trades at a steep valuation discount—16.21x forward earnings versus 22.23x for the S&P 500. Investors have demanded this heavy discount to compensate for perceived risks, even after the spring rebound.

Broad passive inflows into large-cap indices further drain liquidity from the small-cap universe. Yet, these same inefficiencies create pockets of potential alpha for those willing to look beyond headline figures and uncover underappreciated growth stories.

Structural Shifts and Industry Trends

Beyond cyclical factors, the small-cap landscape is reshaping itself. A wave of M&A activity, coupled with companies staying private longer, has reduced the number of publicly traded small caps. This shrinkage in the investable universe intensifies performance swings when volatility spikes.

At the same time, passive investing dominates market flows. Index funds and ETFs tracking large-cap benchmarks have grown exponentially, while dedicated small-cap vehicles command a smaller—and sometimes outflowing—share of assets.

Contrarian Opportunities and Path Forward

History shows that periods of underperformance can mark the setup for outsized gains. Patient investors may find compelling entry points amid the dislocation:

• Focus on balance-sheet health—seek companies with low debt and solid cash reserves.
• Target niche leaders—find small caps with specialized products or dominant local market share.
• Blend active and passive—use ETFs for broad exposure but allocate a portion to handpicked names.

As Paul Cavazos of American Beacon Advisors notes, a good hold for patient investors can yield strong returns over a two- to four-year horizon, once economic headwinds ease.

Perspectives from Market Participants

Analysts at Plante Moran’s Baird emphasize that sensitive to US domestic cycles is the small-cap hallmark in uncertain environments. Charles Schwab highlights that earnings estimates for these businesses cratered in 2023 due to high inflation and wage pressures, setting a low bar for recovery in the coming quarters.

Despite the gloom, contrarian voices point to attractive entry points. The valuation discount, when combined with improving economic data and potential Fed accommodation, could ignite a renewed appetite for nimble, growth-oriented small caps.

Conclusion: Navigating Choppy Waters

Small-cap underperformance amid market stress reflects both cyclical headwinds and long-term structural shifts. While painful in the moment, historical cycles suggest that these troughs often presage periods of strong outperformance.

Investors can navigate this terrain by maintaining diversification, focusing on financial resilience and growth prospects, and balancing passive stability with active insight. By doing so, they position themselves to harness the rebound potential that small-cap stocks have reliably offered after past depths of market turmoil.