Small-Cap Stocks Surge in Q3 2025 as U.S. Economy Thrives

Investors experienced a significant boost in the third quarter of 2025, with U.S. stock indexes reaching new heights, largely driven by a resilient economy and decreasing interest rates. The Russell 2000 Index, which tracks small-cap stocks, advanced by 12.4%, outperforming the Russell 1000 Index, which saw a gain of 8.0%. This marked a long-awaited advantage for smaller companies, highlighting a shift in investor sentiment towards small-cap stocks.

Small-cap growth stocks particularly shone during this period. From April 8 to September 30, the Russell 2000 Growth Index surged by 43.2%, compared to a 35.3% increase for the Russell 2000 Value Index. Moreover, the Russell Microcap Index outperformed its small-cap counterparts with a remarkable rise of 17.0%.

Technology Dominates Large-Cap Gains

While small-cap stocks enjoyed broad-based gains, the performance of large-cap stocks was more concentrated, particularly among technology companies. The Nasdaq Composite rose by 11.4%, while the mega-cap Russell Top 50 Index increased by 10.7% during the quarter, primarily driven by companies with significant exposure to artificial intelligence.

Following a challenging start to 2025, characterized by sharp sell-offs in early April, equities rebounded impressively. The Russell 2000 experienced a 39.9% increase from April 8 to September 30, compared to a 35.2% gain for the Russell 1000. This resurgence was led by the smallest and largest stocks, particularly those in the technology sector.

For the year-to-date period ending September 30, the Russell 2000 rose by 10.4%, while the Russell 1000 increased by 14.6%. Micro-cap stocks continued to outperform, gaining 15.7% year-to-date, while the Russell Top 50 saw a 16.5% increase.

International Stocks Lag Behind

In contrast, non-U.S. stocks experienced more modest gains in the same quarter. The MSCI ACWI ex-USA Small Cap Index rose by 6.7%, while the MSCI ACWI ex-USA Large Cap Index increased by 7.2%. Both indexes demonstrated steady growth throughout 2025, avoiding the bearish sentiment that affected many U.S. indexes earlier in the year.

Year-to-date performance through September showed both the MSCI ACWI ex-USA Small Cap and Large Cap Indexes gaining 25.5%. Despite this, small-cap stocks displayed a slight edge in annualized returns over the longer term.

The dynamics within the small-cap sector also revealed interesting trends. All 11 sectors within the Russell 2000 contributed positively in Q3, with notable performances from Industrials, Information Technology, Health Care, and Consumer Discretionary. Cyclical sectors outperformed defensive sectors, aligning with expectations in a growing economy.

Investors are cautiously optimistic about the future of small-cap stocks, particularly given their relative valuations compared to larger companies. Despite concerns over high valuations among major tech firms, the small-cap segment maintains more reasonable pricing in the current market landscape.

The Russell 2000, as a percentage of the Russell 3000 Index, was at 4.4% at the end of September, significantly below its historical average of 7.6% since late 1984. This suggests that small-cap stocks may offer attractive investment opportunities moving forward.

Anticipating Earnings Growth

Analysts predict that small-cap earnings could outperform those of large-cap firms in 2025, buoyed by recent legislative changes allowing businesses to deduct the entire cost of eligible assets in the year they are placed in service. This could enhance cash flow and provide a boost to small-cap companies that have been navigating a challenging earnings environment.

The overarching theme remains one of resilience despite uncertainties surrounding consumer confidence, job growth, and political divisions. As consumers continue to spend and the economy grows, the combination of lower rates and a vibrant economic backdrop supports the case for small-cap leadership.

Royce Investment Partners emphasizes that while the recent performance of larger stocks may dominate headlines, the potential for small-cap stocks, bolstered by attractive valuations and improving earnings, could lead to sustained growth in the coming years. As always, investors are advised to consider the inherent risks associated with investing in smaller companies, which may involve more volatility compared to larger-cap investments.