The Breakout That Still Has Room to Run

• Small cap stocks broke out last fall.

• This likely signals the start of a new leadership phase.

• The three prior instances have led to outsized gains.

The breakout last fall wasn’t a blip. It was the first signal that small caps were gearing up to run…

Back in September, I noted that small cap stocks started flashing a very different signal. After nearly four years stuck below its 2021 peak, the Russell 2000 Index finally pushed to new highs. The move told you that the market was beginning to rotate toward domestic cyclicals again.

At the time, the Fed had just delivered its first meaningful easing signal, and small caps, with most of their revenue tied to the U.S. economy, were the natural first responders. I noted that breakout wasn’t noise. It was the market’s early read that the pressure valve was opening and above average gains lie ahead for the Russell 2000.

Fast‑forward to today, and the backdrop has only strengthened. Small caps now sit at the intersection of several powerful tailwinds: falling interest rates, improving credit conditions, and a multi‑year AI infrastructure buildout that is driving one of the largest domestic capex cycles in decades.

These companies are the biggest beneficiaries of lower borrowing costs, and they’re positioned to capture the revenue pull‑through from data center construction, grid upgrades, and the broader reindustrialization wave. Wall Street’s expectation for roughly 19% earnings growth in 2026 reflects that alignment. For the first time in years, the macro, the fundamentals, and the positioning all point in the same direction. With small caps still trading at a meaningful valuation discount to large cap stocks, the odds favor another period where this part of the market leads from the front.

But don’t take my word for it, let’s look at what the data’s telling us…

Small caps are stepping into a moment that doesn’t come around often. After two years of grinding under the weight of high rates, tight credit, and an investor base obsessed with mega‑cap safety, the setup has flipped. The combination of falling interest rates, a domestic capex boom tied to AI infrastructure, and a powerful earnings rebound gives small caps something they haven’t had in a long time: the wind at their back.

No part of the equity market is more sensitive to the price of money than the Russell 2000. These companies run on floating‑rate credit, bank loans, and short‑term financing. When the Fed tightens, they feel it at once. But when the Fed eases, the relief is just as fast.

Lower rates cut directly into interest expense, improve cash flow, and widen margins. Because small caps operate with thinner buffers, every 25‑basis‑point cut has an outsized impact on earnings power. Over the last two years, policymakers have eased the federal funds rate by a total of 175 basis points. And this year, the Fed’s expected to ease by another 50 basis points.

This is why Wall Street is projecting roughly 19% earnings growth for the Russell 2000 in 2026. It’s not a heroic assumption. It’s simple math: lower rates plus operating leverage equals a sharp rebound in profitability.

The domestic revenue mix amplifies the effect. Roughly 80% of Russell 2000 sales come from the U.S. That means small caps are tied directly to the health of the domestic economy. And right now, the U.S. is in the early innings of one of the largest domestic investment cycles in decades.

The AI infrastructure buildout is forcing a national expansion of data centers, power systems, transmission lines, cooling capacity, and construction activity. The mega‑caps may write the checks, but the work is done by smaller, regional companies, the exact firms that populate the Russell 2000.

AI infrastructure spending is a multi‑year, non‑discretionary capex cycle driven by power constraints, compute demand, and physical bottlenecks. Every new data center requires excavation, concrete, steel fabrication, electrical installation, HVAC systems, and logistics support. These are labor‑intensive, service‑heavy industries dominated by small caps. Add in the grid upgrade supercycle—transformers, switchgear, substations, line construction—and you have a second wave of demand hitting the same part of the market.

Layer these forces together and the picture sharpens. Small caps get the benefit of falling rates at the exact moment a domestic capex boom is accelerating. They get pricing power from skilled‑trade shortages. They get backlog visibility from multi‑year infrastructure commitments. And they get valuation support from starting at some of the cheapest multiples in the equity market.

History reinforces the setup. The last three times the Russell 2000 broke out to new all‑time highs—2013, 2016, and 2020—the index went on to rally an average of 41% over the following 21 months.

The punchline is simple: after years of being overlooked, this is the moment where small caps can move from afterthought to outperformer. The catalysts are in place, the setup is aligned, and the runway is long. And if history is any guide, the breakout we saw last fall wasn’t the end of the story, it was the opening chapter of the next leg higher.

Five Stories Moving the Market:

The EU is aiming for the “effective stabilization” of trade relations with the U.S., following Donald Trump’s decision to withdraw his threat to impose tariffs on European allies who oppose his proposed annexation of Greenland - FT. (Why you should care – the resolutions of tension between the U.S. and EU appears to have created a new catalyst for clinching a trade deal)

The Bank of Japan kept interest rates steady on Friday and raised its economic and inflation forecasts, signaling its readiness to continue hiking still-low borrowing costs – Reuters. (Why you should care – BOJ Governor Kazuo Ueda said rates are still too low)

China will set a lower economic growth target range for 2026 than last year, reflecting mounting signs that activity will continue to slow; the growth target will be 4.5% to 5% this year, according to the South China Morning Post – Bloomberg. (Why you should care – China’s government has a long‑standing preference for keeping its growth target intact rather than reducing it)

Intel said it struggled to satisfy demand for its server chips used in AI data centers, while forecasting quarterly revenue and profit below market ​estimates; executives said that despite running factories at capacity, Intel cannot keep up with demand for the chips – Reuters. (Why you should care – the demand color should be a tailwind for AI infrastructure companies like Nvidia, Micron, AMD, SK Hynix, and Samsung)

The House of Representatives passed annual funding measures reversing some of the White House’s most controversial federal spending cuts, including restoring money for medical research, refugee assistance and even the Department of Education; the Senate is expected to approve the House’s four-part package, along with two other bills already approved in the House – Bloomberg. (Why you should care – passage of the measures will help the government avoid another shutdown that would take place at the end of the month)

Economic Calendar:

Earnings: BAH, CMA

World Economic Forum in Switzerland

Japan – BoJ Monetary Policy Announcement

Japan – BoJ’s Ueda (Governor) Speaks

Japan – CPI for December

Japan – au Jibun Bank Japan Composite PMI for January

U.K. – Retail Sales for December (2:00 a.m.)

Eurozone – HCOB Eurozone Composite PMI (Preliminary) for January (4:00 a.m.)

U.K. – S&P Global U.K. Composite PMI (Preliminary) for January (4:30 a.m.)

ECB’s Lagarde (President) Speaks (5:00 a.m.)

U.S. – S&P Global U.S. Composite PMI (Preliminary) for January (9:45 a.m.)

U.S. – University of Michigan Consumer Sentiment for January (10:00 a.m.)

U.S. - Baker Hughes Rig Count (1 p.m.)

U.S. - CFTC’s Commitment of Traders Report (3:30 p.m.)

Fed Releases Balance Sheet Updates on Commercial Banks (4:15 p.m.)