Market Backdrop
U.S. equity markets enter 2026 with a setup that has historically created compelling opportunities for disciplined investors. Leadership within U.S. equities remains narrow and expensive, dominated by large-cap growth stocks trading at elevated valuation multiples. In contrast, small-cap equities offer historically attractive valuations and a favorable setup for potential outperformance.
The top ten companies by market capitalization in the S&P 500 Index (S&P 500) now represent 41.1% of the index, while the top ten by earnings represent 32.6% of the index. This concentration is not only narrow, but it is also expensive, with the top ten by weight in the S&P 500 trading at an average of 29 times forward earnings, compared to 19 times for the remaining 490 constituents.
Valuation gaps between value and growth, as well as between small caps and large caps, remain near historical extremes based on nearly all metrics. The Russell 1000 Value Index’s 17 times forward price-to-earnings (P/E) ratio is trading at a 40% discount compared to the Russell 1000 Growth Index’s 29 times P/E, one of the largest discounts since the early 2000s (see following chart).
Similarly, small caps, represented by the Russell 2000 Index, trade at substantial discounts relative to large caps, Russell 1000 Index, including a roughly 30% discount on forward price-to-earnings (see chart below), a 57% discount on price-to-book, and a 44% discount on enterprise value to free cash flow. These valuation disparities underscore the breadth of opportunity within the small-cap universe.
The current market environment bears resemblance to the late 1990s in terms of this growth-to-value, large-to-small disparity. We anticipate mean reversion in the price/earnings multiples commanded by large-cap and artificial intelligence-related stocks relative to small-cap value, although we acknowledge this process can unfold gradually. In our late-1990s analogy, this took approximately two years to fully inflect but ultimately lasted over seven years. With the S&P 500 trading at 22 times forward earnings amid historically narrow leadership, we believe this presents an actionable opportunity for small-cap value equities today, offering higher forward return potential with lower embedded expectations and better asymmetrical payouts. JPMorgan Chase & Co. notes forward five-year annualized S&P 500 total returns are quite low when past multiples have been this high (see chart below).
Concentration risk remains a challenge for large-cap growth investors as index leaders are priced for near-perfection and require elite execution to meet already high embedded expectations, with little margin for error. The catalyst for the re-rating in valuation will be multi-faceted, but it should occur as investors realign their future cash flow expectations with reported earnings. We expect the difference between expectations and reality will be disappointing.
With small-cap value equities generally overlooked by market participants for over a decade, we view the lack of attention to the asset class as a prime opportunity to identify mispricing and drive sustained outperformance over the next number of years. The exploitable market inefficiencies are pronounced in the small-cap space, where limited capital and sell-side analyst coverage enable our team to find mispriced opportunities with asymmetric risk/reward profiles.
With small-cap value equities generally overlooked by market participants for over a decade, we view the lack of attention to the asset class as a prime opportunity to identify mispricing and drive sustained outperformance over the next number of years.
2026 Market Dynamics
Monetary and fiscal policy dynamics are increasingly constructive for small-cap value. We expect additional interest rate cuts through 2026, although the market currently is not pricing these in until early second-quarter of 2026. Cuts could arrive sooner as leading economic indicators continue to weaken. Labor markets are likely to remain the primary driver of policy decisions, as the U.S. Federal Reserve Board (Fed) responds to layoffs and weakening employment conditions, with the goal of accelerating economic growth. Inflation has become a secondary issue for the Fed relative to jobs, and we believe fears of re-accelerating inflation are largely overblown as inflation has moderated.
Looking ahead, with Fed Chair Jerome Powell’s term expiring in May, we expect a Trump-appointed successor to pursue a more stimulative monetary policy overall. This shift may lead to a steepening yield curve, with the long end rising on expectations of higher growth and investor hesitancy to purchase long-term paper given the fiscal deficit and debt imbalances. We are closely watching this dynamic as it may prove challenging for mortgages. Notably, the Fed has recently resumed quantitative easing (QE), purchasing assets to help the cash markets. It is possible the Fed may extend these plans to mortgage-backed securities or 10-year Treasuries to lower mortgage rates, a potentially significant development that remains underdiscussed. This drift back toward the post-credit crisis QE playbook should be positive for the U.S. economy and risk assets in the near term.
Tax and trade measures enacted or extended by the current U.S. administration are expected to increasingly flow through to the real economy in 2026, disproportionately benefiting domestically focused small-cap value companies. We are also monitoring a U.S. Supreme Court case regarding the constitutionality of certain tariffs, which could introduce additional volatility in select industries.
Taken together, these dynamics favor many of the end markets and companies represented across our portfolio. Financials stand to benefit from a steepening yield curve, while Industrials, Materials, and Information Technology companies are well positioned for ongoing onshoring initiatives. Consumer Discretionary companies may benefit from a resilient U.S. consumer, and the Health Care sector has become an increasingly attractive area as demographic trends and policy developments create new opportunities.
As long-tenured contrarians, we maintain a cautious view of consensus sell-side forecasts and public sentiment, which appear to be generally positive. Geopolitical uncertainty remains elevated abroad while domestically, the current U.S. administration has shown a penchant for maneuvering outside of established norms.
Somewhat concerning is the proliferation of private credit. The recent emergence of fraud and credit deterioration has caused trouble for many investors and financial institutions. We are looking at this area of the market with great interest to make sure spillover effects stemming from lending and underwriting by non-expert participants are contained and manageable.
ncouragingly, we have begun to see instances of asset flows rotating back into value, and small-cap value equities specifically. We expect this to be an additional tailwind that supports small-cap value over the intermediate term, and we view today’s setup as the opportune time for small-cap active value exposure. Forces that have worked against small-cap value and active management for the last decade now represent a material go-forward opportunity. Specifically, fewer active participants and increased correlations across index constituents are providing even more avenues for our established process to identify mispricing and drive meaningful risk-adjusted returns.
Forces that have worked against small-cap value and active management for the last decade now represent a material go-forward opportunity.
IMPORTANT INFORMATION
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