BofA: Small caps back in the spotlight, tailwinds for further rally in place

After the spring selloff, small-cap stocks are once again attracting investor attention, BofA said in a market outlook report earlier this week. But this is not a short-term rebound: easing from the Fed, rising earnings, and less taxes could support a sustained increase in small-cap valuations.

After a long period out of the spotlight, small-cap stocks are once again drawing attention, according to the latest market outlook report put out by BofA.

The Russell 2000 index is trading near record highs, having gained more than 9% between August 1 and August 31. Over the same period, the S&P 500 rose 3.5%. For the first time in more than a year, the benchmark for smaller companies has outperformed the index of large-cap stocks, BofA analysts noted.

While previous rallies have tended to fizzle, an increasing number of supportive factors are fueling optimism that the current rebound could prove more sustainable, the analysts added.

Monetary policy easing is the strongest factor supporting the continuation of the rally, according to BofA. Last week, the Fed cut interest rates by 25 basis points to 4.00-4.25%. This was the first rate cut of 2025. Since 1990, shares of smaller companies have, on average, outperformed large caps in the first 24 months following Fed rate cuts. One reason is that small-cap companies are more sensitive to changes in interest rates: they carry heavier debt loads, and about 45% of their borrowings are short-term or floating-rate.

Earnings recovery is another major tailwind. BofA analysts note that small caps just reported year-over-year EPS growth for the first time since 2022. They expect the pace of small-cap earnings growth to surpass that of large caps by the end of 2025. Royce analysts share this view, projecting EPS growth of 31.8% for small caps versus 8.1% for large caps by year-end.

Market indicators also support the outlook. The BofA Global Research U.S. Regime Indicator has entered “recovery” territory, a phase that has historically been the most favorable for small-cap performance. While valuations have risen alongside the summer rebound, forward P/E multiples remain below historical averages.

Policy changes could provide further support. Provisions in Trump’s “Big Beautiful Bill” relax rules on business tax deductions, allowing companies to include depreciation and amortization when calculating adjusted taxable income. Since small-cap companies typically have nearly double the depreciation and amortization of large caps, this measure could benefit them disproportionately, BofA notes.

Finally, a resurgence in M&A and IPO activity could act as an additional catalyst. Early September marked the most active IPO period since 2021, with six deals raising more than $4 billion, according to Business Insider.

That’s not to say that the rally is without risks, BofA cautions. A weaker-than-expected macro backdrop could disproportionally impact small caps, as they are typically more sensitive to domestic economic cycles.

Small caps also remain prone to lingering tariff uncertainty, as higher costs could eat into margins that are already thin compared to their large-cap peers.

There are still risks that bear watching, but investors may consider incorporating high-quality small caps with solid fundamentals as part of a balanced portfolio, BofA said.

The AI translation of this story was reviewed by a human editor.