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

A stock market surprise almost a decade in the making could arrive this year.

Experts have time and again called for small-company stocks—roughly defined as those with market capitalizations below $2 billiobn—to outperform large-company shares. And they’ve been wrong for the past nine years. This year, according to State Street chief investment strategist Michael Arone, that could change.

If it does, investors will likely be caught off guard: They pulled some $12 billion from small-cap ETFs over the past year through the end of January, according to Arone. Meanwhile, the Russell 2000, an index of small-cap companies, has risen 8% year-to-date, well ahead of the Russell 1000 or S&P 500.

Arone offered that as one of three 2026 predictions in a recent report, the other two being that healthcare stocks will outperform the broader market, and that inflation will undershoot expectations.

Market folklore—that January is an indicator for the rest of the year—signals small-cap outperformance, but a slew of fundamental and macroeconomic factors could also put the wind in small-company sails, including a weaker dollar and deregulation boosting IPO activity, Arone wrote earlier this week.

Expectations of lower interest rates also bode well for small-cap companies, and the impact is becoming more visible: “Interest expense for small companies has been declining and should continue to fall as the Fed extends its rate cutting cycle,” he said.

Lower rates would boost small-cap profitability, and consensus estimates for small-cap earnings for 2026 exceed large-cap companies’, he said.

That said, the Federal Reserve Open Market Committee isn’t expected to lower rates this year until June, according to CME FedWatch, when Chair Jerome Powell’s term ends and his successor—Trump’s nominee is Kevin Warsh—steps in.

The Bureau of Labor Statistics’ consumer price index report on Friday should show relatively lower price increases for the month of January. Rising oil prices, which have historically coincided with higher inflation, may not instill much confidence in investors. But Arone expects the jump in oil prices, primarily driven by concerns of supply disruption related to geopolitical tensions, will be “short lived.” Arone’s predicts that tariff-related price increases will drop off by the middle of the year and that ultimately, “inflation surprises to the downside.”

Another set of underloved stocks that could deliver big gains: healthcare. ETFs tracking the sector have seen net inflows of just $537 million in the 12 months ended January, while the industrials sector had some $10.6 billion, Arone said. That would make sense given the sector’s lackluster performance lately, which has driven its overall weight in the S&P 500 to a 40-year low, he said.

The Health Care Select Sector SPDR ETF (XLV) over the past five years produced the second-lowest returns of the other sector funds, behind just real estate. So far this year, it’s in the middle of the pack.

The sector’s depressed valuations relative to the broader stock market makes for a “compelling” opportunity, Arone said. Investors appeared to favor so-called value stocks as last week’s volatility drove them to tweak their portfolios. That health care stocks tend to outperform the broader market in mid-term election years also bodes well for the sector this year, he said.