Nathan Moser: AI Hype Hiding Comeback in Small-cap Stocks

Small-cap rally may just be starting

Small-cap stocks are often viewed as higher-risk, higher-reward assets, typically cycling through periods of underperformance followed by bursts of growth. Historically, small-cap stocks tend to go through long cycles of outperformance and underperformance that can last over a decade.

According to Moser, the most recent period of small-cap underperformance lasted roughly 13 to 14 years, ending around April 2025. Since that inflection point, small caps have outpaced large caps by about 12 percent.

“What’s interesting to me is that outperformance has been a fairly quiet experience,” he noted, adding that clients and media contacts are often surprised to hear how well small caps have done. “It just tells you really how much focus has been on the mega-cap tech names and artificial intelligence (AI).”

For Moser, valuation is the key precondition for sustained outperformance. “It’s hard for an asset class to really meaningfully outperform if it’s starting from a place of expensive valuations,” he explained.

At levels reminiscent of the late 1990s, current valuations are an attractive entry point for investors.

Small caps have become more affordable relative to large caps, especially with the intense focus on mega-cap tech companies and AI hype. This crowding in mega caps has created opportunities for savvy investors to rotate into smaller, undervalued firms. Furthermore, there's a noticeable shift toward more defensive positioning.

“We’re seeing an intentional move to reposition portfolios in a more defensive manner,” said Moser, citing the overcrowding in the tech sector and the desire for better risk-adjusted returns.

Some investors are rotating down the market cap spectrum to hedge against potential volatility, especially amid geopolitical tensions like the Iran war, which could have broader economic implications.

Why small-cap stocks are outperforming

The rotation of funds from mega-cap tech giants into smaller, more domestically focused companies signals a change in investor sentiment as market participants begin to diversify.

One of the primary drivers behind this rally is the expectation of accelerating earnings growth in small caps. Moser said consensus estimates forecast over 20 percent earnings growth for small-cap companies this year and the next.

This earnings momentum, coupled with attractive valuations, creates a fertile ground for outperformance.

Moderating inflation, declining interest rates and potential monetary stimulus are tailwinds for small caps. Lower borrowing costs tend to benefit smaller companies, which often have higher leverage.

Another significant tailwind for small caps is the trend towards moderating inflation.

The potential for the US Federal Reserve to cut rates later this year or in 2027 could extend the economic cycle, providing additional support for small-cap stocks.

Key sectors to watch

While a broad market rotation is happening, specific sectors stand out for Moser. He believes healthcare, particularly biotech, is underappreciated, with high-quality firms profitable and resilient amid market volatility.

Ligand Pharmaceuticals (NASDAQ:LGND), Neurocrine Biosciences (NASDAQ:NBIX) and Trevere Therapeutics (NASDAQ:TVTX) exemplify the type of company that's poised for growth and potential acquisition.

Further, the potential for AI integration makes biotech a compelling area for growth. AI is revolutionizing biotech by accelerating drug discovery, optimizing clinical trials and improving regulatory pathways. Companies leveraging AI effectively can achieve faster development cycles and more accurate targeting, making this a sector to monitor closely.

Other sectors contributing to the small-cap rise include industrials and technology infrastructure companies involved in building data centers and supporting AI development.

Infrastructure firms supporting thermal management are also integral to AI expansion.

Risks that could reverse momentum

Although valuations are attractive now, they could revert if market enthusiasm for AI and tech infrastructure diminishes. Overheated sectors may face corrections, especially if macro conditions worsen or monetary policy shifts.

The most significant risk to this nascent rally in small-cap stocks is a prolonged conflict involving Iran, which could trigger a surge in oil prices and escalate inflation. If energy prices spike sharply or a broader geopolitical crisis unfolds, investor confidence may be dampened and current momentum could reverse.

For biotech and healthcare, risks include regulatory changes and clinical trial setbacks. For example, biotech companies heavily reliant on R&D progress or regulatory approvals could face delays or failures, affecting their growth prospects.

Investor takeaway

The evidence suggests that the market is in the early innings of a potentially long-lasting small-cap rally. Valuations are attractive, fundamentals are promising and sector dynamics favor growth. The current environment offers a rare chance to buy small caps at attractive valuations, especially those with solid earnings prospects. The key is identifying high-quality, profitable companies that can withstand macroeconomic headwinds.

However, vigilance is necessary. Risks like geopolitical conflicts and sector corrections could weigh on enthusiasm if not managed wisely. A disciplined approach, focusing on high-quality companies with strong fundamentals, can help capitalize on this promising environment.

Given the risks, diversification remains vital. Investors should tailor their portfolios to include resilient small-cap stocks that can perform across different scenarios.