Is the small-cap rally coming to an end? 4 rules for picking stocks as the Fed raises rates

For most of the year, investors bought small-cap stocks in an effort to diversify their portfolios and reduce their reliance on a narrow group of AI-related securities. The first half of 2026 was the most successful for the Russell 2000 since 1991: the index rose 21%, outperforming major U.S. stock indices. However, the prospect of further Fed rate hikes threatens the small-cap rally, according to Bloomberg. Small companies are more dependent on debt financing and react more sharply to rising borrowing costs.

At the request of Oninvest, Vadim Merkulov, director of the analytics department at Freedom Finance Global, outlined four rules for investors on how to select stocks of small companies amid rising interest rates.

The Russell 2000’s outperformance relative to the S&P 500 since the start of the year has narrowed from 11 percentage points in June to just 2 points, according to Bloomberg. The index itself has fallen below its 50- and 100-day moving averages, while the indices of large-cap companies continue to trade above those levels.

The Russell 2000’s rebalancing posed an additional challenge, the agency notes. Four companies— Bloom Energy, Credo Technology, Sterling Infrastructure, and TTM Technologies —accounted for two-thirds of the index’s gains through June 29, and were subsequently moved to the Russell 1000. Along with them, other beneficiaries of the AI boom also left the index. As a result, the average company in the Russell 2000 has become smaller and more sensitive to interest rate hikes.

That said, it’s too early to write off small-cap stocks entirely: in the last quarter, their earnings grew at the fastest pace since 2022, according to Bloomberg, citing data from Jefferies. However, analysts surveyed by the agency expect the sector’s future performance to be less uniform: instead of buying the entire index, investors will have to be more selective in choosing profitable companies with stable businesses and moderate debt levels.

— Avoid companies with high debt levels

Rate hikes have almost no impact on large companies, whereas small-cap companies are vulnerable due to their business and debt structures. Interest expenses for companies in the Russell 2000 account for about 31% of EBITDA, compared with 6.7% for companies in the S&P 500, notes Vadim Merkulov. In addition, approximately 30% of their debt is tied to a floating rate—compared with about 7% for large-cap companies. Nearly 40% of Russell 2000 constituents remain unprofitable.

Merkulov advises avoiding heavily indebted developers—companies whose product demand depends on the availability of consumer credit—as well as unprofitable biotech firms that will soon need new financing. More sustainable investment opportunities can be found among energy companies, profitable medical equipment manufacturers, producers of essential goods, and insurers.

— Focus on quality, not the entire Russell 2000

Merkulov believes that the rally in the Russell 2000 index has most likely already come to an end. Individual profitable companies with a sustainable business model—for example, those with a high proportion of recurring revenue—may continue to perform well.

The S&P SmallCap 600 looks more promising, as it includes companies of higher financial quality. Merkulov believes its growth could continue at a faster pace. However, the S&P 500 still looks more attractive: corporate earnings growth this year is so high that it more than compensates for the increase in the key interest rate. The situation is more complicated in the small-cap segment.

— Check the debt and its repayment terms

When conducting an initial screening of non-financial companies, Vadim Merkulov recommends focusing on a net debt-to-EBITDA ratio below 2–3 and an interest coverage ratio—measured by operating profit (EBIT)—above four.

Another key indicator is the amount of debt that must be repaid or refinanced in the next 6–24 months. New financing will cost companies more. At the same time, Merkulov emphasizes that he does not expect a repeat of the same aggressive cycle of rate hikes as in 2022: this time, he believes, it will likely be more moderate.

Once you’ve narrowed down your list of companies, it’s worth reviewing Section 7A of the Form 10-K annual report. In this section, many issuers estimate how much their interest expenses would increase if interest rates rose by 1 percentage point. This will help investors assess potential risks.

— Don't exit small-cap stocks entirely, but reduce your exposure

Merkulov does not recommend completely eliminating small-cap stocks from a portfolio, but he does advise focusing on higher-quality assets—such as companies in the S&P SmallCap 600 or specific stable sectors.

Experienced investors can supplement their long positions in high-quality companies by betting on a decline in the Russell 2000 using put options that expire by the end of the year. However, this is a speculative strategy and is not suitable for everyone, Merkulov warns.

A shift in expectations regarding the trajectory of interest rates, as well as an actual decline in Treasury yields and credit spreads, could signal a broader return to small-cap stocks.

This is not intended as individual investment advice.