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Volume 14, Edition 30 | September 22 - September 28, 2025

Small Caps: Sensitivity, Struggles, and Signs of Life

Doug Walters, CFA
In this week’s Insights, we explore why small caps are so sensitive to interest rates, what their recent performance tells us, and how they fit into a well-diversified portfolio.

Contributed by Doug Walters, David Lemire, Max Berkovich, Matthew Johnson

For much of the past few years, small cap stocks have taken a backseat to their larger cousins. While large cap growth dominated headlines and portfolios—under a rotating cast of acronyms from FANG, FAAMG, Mag7, etc.—small caps lagged, held back by rising interest rates, tighter financial conditions, and a flight to perceived safety. But recent months have brought a subtle shift, and we use this moment as an opportunity to revisit their role in a well-diversified portfolio.

Small caps are uniquely sensitive to interest rates. With shorter debt maturities and a greater reliance on financing (particularly floating rate), they tend to feel the pinch of rising rates more acutely than their large cap counterparts. That sensitivity has been a headwind as the Fed raised rates. Since the end of 2020, the S&P 500 has outperformed the Russell 2000 by well over 50%.

A Turning Tide

But the tide may be turning. Over the past three months, small caps have quietly outpaced large caps, as rate cutting has resumed. While one quarter doesn’t make a trend (in fact they underperformed last week), it is possible small caps may be regaining their footing.

Portfolio Benefits

From a portfolio construction perspective, small caps offer distinct advantages. They tend to be more domestically focused and have more dynamic businesses that can enhance diversification when paired with large cap, international, and fixed income exposures. Despite the trends of the last decade, their relative historical return profile has been strong over full market cycles, and their current valuations remain attractive relative to large caps.

Timely Housekeeping

Small caps have struggled, but they’re stirring. In a well-diversified portfolio, they play a vital role—not just as a return engine, but as a counterbalance to other narratives (like mega-cap stocks getting increasingly concentrated and expensive). If the past decade has found your equity exposure drifting too much towards mega-caps, now is as good a time as any to right-size that exposure. We’re not predicting small-cap outperformance. Rather advocating for smart portfolio maintenance.

2.9%

Core PCE Inflation

The Fed’s preferred measure of inflation ticked up ever-so-slightly (from 2.85% to 2.91%) but managed not to breach the 3% mark. The Fed would prefer to see inflation closer to 2% though are probably content not to see a marked increase.

Headline of the Week

This Time It’s Different

This week’s headline is one of the more dangerous phrases on Wall Street. Whenever a theme goes exponential, reasonable people often reach for another phrase: “History doesn’t repeat, but it rhymes.”

Today, concerns are mounting that the Artificial Intelligence (AI) buildout is starting to resemble the fiber-optic boom of the 1990s. The “different” camp points out that today’s capacity is being funded by cash-rich giants like Microsoft, Meta, and Alphabet—a stark contrast to the debt-fueled telecom players of the past.

But here’s the rhyme: spending is vastly outpacing revenue and cost savings.

If you build it, they will come. For fiber, the buildout ultimately bore fruit—but not on the timeline anyone expected. It’s hard to imagine this AI cycle won’t deliver some transformative outcomes, but the timing could be far different than many believe.

There will likely be pain—could OpenAI be the Netscape of this era? And there will likely be gain—some breakthrough application that redefines the landscape (think iPhone, email, Google Search). It’s hard to believe a chatbot is the pinnacle.

In the end, maybe this time really is different—but expect plenty of rhymes along the way.

The Week Ahead

As the government shutdown drama builds into the new month, it is easy to lose focus, but a critical jobs report is on the docket on Friday as well as an economic activity report from Institute of Supply Management (ISM).

Work Out

After a shocking revision of previous non-farm payroll (NFP) numbers and an August report of 22,000 new jobs, which was significantly below the expected 75,000. Friday’s September jobs report will be heavily scrutinized.

  • Consensus expectations are 39,000 new jobs, with the unemployment rate staying steady at 4.3%.
  • Weekly earnings are expected to move up a bit by 0.3%, same as in the last report.
  • ADP employment change, the Job Openings and Labor Turnover Survey (JOLTS) and Challenger, Grey and Christmas’ job cuts report will help fill in the employment picture a few days before the NFP.
  • We may not get a report at all, if there is a government shutdown or even a partial shutdown. The Bureau of Labor Statistics, an agency of the U.S. Department of Labor, may not be operating.

Staying Active

The ISM purchasing manager index (PMI), one for manufacturing on Wednesday and one for services on Friday will help paint the picture of economic activity in September.

  • Economists expect manufacturing activity to improve to 49.2, versus 48.7 in the previous reading, but stay below 50, meaning it is still in contraction.
  • On the services side the reading is expected to be unchanged at 52 and continue in the expansion column.

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